Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
.
.
S
t
o
c
k
h
o
l
d
e
r
A
p
p
r
o
v
a
l
n
e
e
d
e
d
These actions could all suggest that managerial interests are being put over
stockholder interests. (Some of these actions, though, may also increase
stockholder wealth. Managers will, of course, always claim that these actions are
in stockholders best interests)
Aswath Damodaran 20
Overpaying on takeovers
! The quickest and perhaps the most decisive way to impoverish stockholders is
to overpay on a takeover.
! The stockholders in acquiring rms do not seem to share the enthusiasm of
the managers in these rms. Stock prices of bidding rms decline on the
takeover announcements a signicant proportion of the time.
! Many mergers do not work, as evidenced by a number of measures.
The protability of merged rms relative to their peer groups, does not increase
signicantly after mergers.
An even more damning indictment is that a large number of mergers are reversed
within a few years, which is a clear admission that the acquisitions did not work.
Managers of acquiring rms almost always make every acquisition sound like a
good idea. Stockholders are more skeptical (as is evidenced by the behavior of
acquiring rm stock prices on the announcement of acquisitions).
Stockholders must be right, on average, since many takeovers do not seem to
work in terms on increasing stockholder wealth or making the rms more
efcient.
(Good references
The Synergy Trap, Mark Sirower)
Aswath Damodaran 21
A Case Study: Kodak - Sterling Drugs
! Eastman Kodaks Great Victory
Note the difference in stock price behavior of the target and bidding rms.
Note also the symmetry between premium paid over the market price at Sterling
Drugs ($ 2.1 billion) and value lost at Kodak ($2.2 billion). Kodak argued that
this merger would create synergy and that was why they were paying the
premium. The market did not seem to see any synergy.
Aswath Damodaran 22
Earnings and Revenues at Sterling Drugs
Sterling Drug under Eastman Kodak: Where is the synergy?
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
1988 1989 1990 1991 1992
Revenue Operating Earnings
Where is the synergy?
Prots essentially stagnated at Sterling after the Kodak acquisition. The rest of
the drug industry reported an annual growth in earnings of 15% a year during
this period.
Why is synergy so hard to capture?
Firms do not plan for it at the time of the acquisitions
Culture shock
Unrealistic assumptions (AT&T and NCR)
Aswath Damodaran 23
Kodak Says Drug Unit Is Not for Sale (NY Times, 8/93)
! An article in the NYTimes in August of 1993 suggested that Kodak was eager to shed its drug unit.
In response, Eastman Kodak ofcials say they have no plans to sell Kodaks Sterling Winthrop drug unit.
Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as massive speculation, which ies in the face of the stated
intent of Kodak that it is committed to be in the health business.
! A few months laterTaking a stride out of the drug business, Eastman Kodak said that the Sano Group, a French
pharmaceutical company, agreed to buy the prescription drug business of Sterling Winthrop for $1.68 billion.
Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock Exchange.
Samuel D. Isaly an analyst , said the announcement was very good for Sano and very good for Kodak.
When the divestitures are complete, Kodak will be entirely focused on imaging, said George M. C. Fisher, the company's chief
executive.
The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.
As in the old Soviet Union, nothing is true until it is ofcially denied.
Aswath Damodaran 24
!Application Test: Who owns/runs your rm?
Look at: Bloomberg printout HDS for your rm
! Looking at the top 15 stockholders in your rm, are top managers in your rm
also large stockholders in the rm?
! Is there any evidence that the top stockholders in the rm play an active role
in managing the rm?
You can also get this information from Yahoo! Finance by going into company
proles and clicking on institutional investors
Aswath Damodaran 25
Disneys top stockholders in 2003
Not a single individual investor in the list other than Roy Disney who was the
15th largest stockholder Managers are not signicant stockholders in
Disney (and the same can be said for most large publicly traded rms).
The response is not to give them options since owning options does not create
the same incentives as owning shares
Consider the following scenarios:
1. Managers are not signicant stockholders in the rm: Signicant potential
for conicts of interest between managers and stockholders.
2. Individuals are signicant stockholders in the rm as well as part of top
management. Usually, these are founder-owners of the rm and the rms
tend to be younger rms or family run businesses that have recently made
the transition to publicly traded rms. Smaller potential for conict between
managers and stockholders, but potential for conict between inside
stockholders and outside stockholders.
3. Trusts or descendants of owners are signicant stockholders in the rm but
are not an active part of incumbent management. Power that these
stockholders retain to replace managers reduces potential for conict of
interest but power is reduced as holdings get diluted among lots of family
members.
4. Another company is largest stockholder in rm. In this case, trace out who
owns stock in the other company.
Aswath Damodaran 26
A confounding factor: Voting versus Non-voting Shares -
Aracruz
! Aracruz Cellulose, like most Brazilian companies, had multiple classes of
shares at the end of 2002.
The common shares had all of the voting rights and were held by incumbent
management, lenders to the company and the Brazilian government.
Outside investors held the non-voting shares, which were called preferred shares,
and had no say in the election of the board of directors. At the end of 2002,
! Aracruz was managed by a board of seven directors, composed primarily of
representatives of those who own the common (voting) shares, and an
executive board, composed of three managers of the company.
When voting rights vary across shares, incumbent managers can consolidate
their hold on a company with relatively small holdings. This reduces the power
that stockholders have in these companies.
Differences in voting rights are common outside the U.S. In Asia and Latin
America, incumbent managers or family members can control companies with
relatively small holdings with complete impunity.
Aswath Damodaran 27
Another confounding factor Cross Holdings
! In a cross holding structure, the largest stockholder in a company can be
another company. In some cases, companies can hold stock in each other.
! Cross holding structures make it more difcult for stockholders in any of the
companies involved to
decipher what is going on in each of the individual companies
decide which management to blame or reward
change managers even if they can gure out who to blame.
Deutsche is the largest stockholder in Daimler Chrysler, the German automobile
company, and Allianz, the German insurance company, is the largest stockholder
in Deutsche.
Aswath Damodaran 28
II. Stockholders' objectives vs. Bondholders' objectives
! In theory: there is no conict of interests between stockholders and
bondholders.
! In practice: Stockholder and bondholders have different objectives.
Bondholders are concerned most about safety and ensuring that they get paid
their claims. Stockholders are more likely to think about upside potential
Bondholders include all lenders (including banks). The actions listed above
transfer wealth from them to stockholders.
Aswath Damodaran 29
Examples of the conict..
! Increasing dividends signicantly: When rms pay cash out as dividends,
lenders to the rm are hurt and stockholders may be helped. This is because
the rm becomes riskier without the cash.
! Taking riskier projects than those agreed to at the outset: Lenders base
interest rates on their perceptions of how risky a rms investments are. If
stockholders then take on riskier investments, lenders will be hurt.
! Borrowing more on the same assets: If lenders do not protect themselves, a
rm can borrow more money and make all existing lenders worse off.
In each of these cases, you are likely to see stock prices go up on the action and
bond prices go down.
Aswath Damodaran 30
An Extreme Example: Unprotected Lenders?
Nabiscos bond price plummeted on the day of the LBO, while the stock price
soared.
Is this just a paper loss? (You still get the same coupon. Only the price has
changed)
Not really. There is now a greater chance of default in Nabisco, for
which you as a lender are not compensated.
How could Nabiscos bondholders have protected themselves?
Put in a covenant that allowed them to turn the bonds into the rm in the
event of something like an LBO and receive the face value of the bond.
(Puttable bonds)
Make the coupon payments on the bond a function of the companys
rating (Rating sensitive bonds)
Aswath Damodaran 31
III. Firms and Financial Markets
! In theory: Financial markets are efcient. Managers convey information
honestly and and in a timely manner to nancial markets, and nancial
markets make reasoned judgments of the effects of this information on 'true
value'. As a consequence-
A company that invests in good long term projects will be rewarded.
Short term accounting gimmicks will not lead to increases in market value.
Stock price performance is a good measure of company performance.
! In practice: There are some holes in the 'Efcient Markets' assumption.
An efcient market is one where the market price reects the true value of the
equity in the rm (and any changes in it). It does not imply perfection on the
part of markets, but it does imply a link between what happens to the stock price
and what happens to true value.
Aswath Damodaran 32
Managers control the release of information to the general
public
! Information (especially negative) is sometimes suppressed or delayed by
managers seeking a better time to release it.
! In some cases, rms release intentionally misleading information about their
current conditions and future prospects to nancial markets.
Consider an example of Bre-X, which told markets that it had found one of the
largest gold reserves in the world in Indonesia in the early 1990s. In 1997, it
was revealed that there was no gold, and that the rm had salted the mine with
gold to fool investors. When the news eventually came out, the stock price
dropped to zero.
Bre-X was followed by 9 analysts, all of whom professed to be shocked by the
revelation.
Aswath Damodaran 33
Evidence that managers delay bad news..
DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by
Weekday
-6. 00%
-4. 00%
-2. 00%
0.00%
2.00%
4.00%
6.00%
8.00%
Monday Tuesday Wednesday Thur sday F r i da y
% Chg(EPS) % Chg(DPS)
This study looked at thousands of earnings and dividend announcements,
categorized by day of the week in the 1980s. Either bad things tend to happen
on Fridays, or managers are trying to hold on to bad news until Friday. In fact,
most of the bad news on Friday comes out after 4 pm, and markets have closed.
Managers do not trust markets to not panic on bad news.
This may explain a portion of the weekend effect - stock prices tend to go down
on Mondays.
Aswath Damodaran 34
Some critiques of market efciency..
! Prices are much more volatile than justied by the underlying fundamentals.
Earnings and dividends are much less volatile than stock prices.
! Financial markets overreact to news, both good and bad.
! Financial markets are manipulated by insiders; Prices do not have any
relationship to value.
! Financial markets are short-sighted, and do not consider the long-term
implications of actions taken by the rm.
The Shiller effect - stock prices are much volatile than justied by looking at the
underlying dividends and other fundamentals - is debatable. While people often
present anecdotal evidence on the phenomenon, they under estimate the volatility
of the underlying fundamentals.
For every researcher who claims to nd evidence that markets overreact, there
seems to be another researcher who nds evidence that it under reacts. And no
one seems to be able to systematically make real money (as opposed to
hypothetical money) on these supposed over or under reactions.
Corporate strategists, like Michael Porter, argue that market prices are based
upon short term forecasts of earnings and do not factor in the long term.
In markets outside the US, the argument is that prices are moved by insiders and
that they have no relationship to value.
Aswath Damodaran 35
Are Markets Short term?
! Focusing on market prices will lead companies towards short term decisions
at the expense of long term value.
a. I agree with the statement
b. I do not agree with this statement
! Allowing managers to make decisions without having to worry about the
effect on market prices will lead to better long term decisions.
a. I agree with this statement
b. I do not agree with this statement
This again has no right answers. Most participants, given the barrage of
criticism that they hear about markets on the outside, come in with the
perception that prices are short term.
Aswath Damodaran 36
Are Markets short term? Some evidence that they are
not..
! There are hundreds of start-up and small rms, with no earnings
expected in the near future, that raise money on nancial markets. Why
would a myopic market that cares only about short term earnings attach
high prices to these rms?
! If the evidence suggests anything, it is that markets do not value current
earnings and cashows enough and value future earnings and cashows
too much. After all, studies suggest that low PE stocks are under priced
relative to high PE stocks
! The market response to research and development and investment
expenditure is generally positive.
None of these pieces of evidence is conclusive proof that markets are long term,
but the evidence does add up to markets being much more long term than
they are given credit for. There is little evidence, outside of anecdotal
evidence, that markets are short term.
The best support for markets comes from looking at how well they do relative to
expert prognosticators:
1. Forward currency rates are better predictors of expected currency rates in
the future than economic forecasters.
2. Orange juice futures markets seem to predict the weather in Florida better
than weather forecasters.
3. The Iowa Election Market has predicted election results better than political
pundits.
It is true that there are many short term investors and analysts in the market, but
the real question is whether the market price is able to get past their short
term considerations and focus on the long term. Sometimes, it does not but
surprisingly often, it does.
Aswath Damodaran 37
Market Reaction to Investment Announcements
Note that the price increases tend to be small, since these announcements tend to
affect value by only small amounts. The effect seems to correlate with the
weightiness of each announcement, being lower for product strategy
announcements (which might signify little or no real investment) and being
higher for the other three.
Markets also tend to be discriminating and look at both the type of business
where the R&D is being spent (Intel versus Kellogg) and the track record of the
managers spending the money.
Aswath Damodaran 38
IV. Firms and Society
! In theory: There are no costs associated with the rm that cannot be traced
to the rm and charged to it.
! In practice: Financial decisions can create social costs and benets.
A social cost or benet is a cost or benet that accrues to society as a whole and
not to the rm making the decision.
Environmental costs (pollution, health costs, etc..)
Quality of Life' costs (trafc, housing, safety, etc.)
Examples of social benets include:
creating employment in areas with high unemployment
supporting development in inner cities
creating access to goods in areas where such access does not exist
Social costs and benets exist in almost every nancial decision.
Aswath Damodaran 39
Social Costs and Benets are difcult to quantify because ..
! They might not be known at the time of the decision (Example: Manville and
asbestos)
! They are 'person-specic' (different decision makers weight them differently)
! They can be paralyzing if carried to extremes
Economists measure social benets in utils . Few, if any, businesses have
gured out a way of actually putting this into practice.
Aswath Damodaran 40
A Hypothetical Example
Assume that you work for Disney and that you have an opportunity to open a
store in an inner-city neighborhood. The store is expected to lose about
$100,000 a year, but it will create much-needed employment in the area, and
may help revitalize it.
! Would you open the store?
a) Yes
b) No
! If yes, would you tell your stockholders and let them vote on the issue?
a) Yes
b) No
! If no, how would you respond to a stockholder query on why you were not
living up to your social responsibilities?
I do this survey in three parts.
First, I allow people to make the choice of whether they would open the store. I
then pick someone who would open the store and press them on whether they
would reveal this to their stockholders. If the answer is No, I point out that it is
after all the stockholders wealth. If the answer is Yes, I then ask them whether
they would let stockholders vote (if not on individual store openings, on the
money that the rm will spend collectively on being socially responsible)
I also ask people why they would open the store. If the answer is that they
would do it for the publicity, I counter that it is advertising and not social
responsibility that is driving the decision. There is nothing wrong with being
socially responsible and getting economically rewarded for it. In fact, if societies
want to make rms socially responsible they have to make it in their economic
best interests to do so.
Aswath Damodaran 41
So this is what can go wrong...
STOCKHOLDERS
Managers put
their interests
above stockholders
Have little control
over managers
BONDHOLDERS
Lend Money
Bondholders can
get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad
news or
provide
misleading
information
Markets make
mistakes and
can over react
Signicant Social Costs
Some costs cannot be
traced to rm
This is my worst case scenario:
Stockholders have little or no control over managers. Managers,
consequently, put their interests above stockholder interests.
Bondholders who do not protect themselves nd stockholders
expropriating their wealth.
Information conveyed to markets is noisy, biases and sometimes
misleading. Markets do not do a very good job of assimilating this
information and market price changes have little to do with true value.
Firms in the process of maximizing stockholder wealth create large
social costs.
In this environment, stockholder wealth maximization is not a good objective
function.
Aswath Damodaran 42
Traditional corporate nancial theory breaks down when ...
! The interests/objectives of the decision makers in the rm conict with the
interests of stockholders.
! Bondholders (Lenders) are not protected against expropriation by
stockholders.
! Financial markets do not operate efciently, and stock prices do not reect the
underlying value of the rm.
! Signicant social costs can be created as a by-product of stock price
maximization.
This summarizes the break down in each of the linkages noted on the previous
page.
Aswath Damodaran 43
When traditional corporate nancial theory breaks down, the
solution is:
! To choose a different mechanism for corporate governance
! To choose a different objective for the rm.
! To maximize stock price, but reduce the potential for conict and breakdown:
Making managers (decision makers) and employees into stockholders
By providing information honestly and promptly to nancial markets
At this point, things look pretty bleak for stock price maximization. These are
the three choices that we have, if we abandon pure stock price maximization as
an objective function.
Aswath Damodaran 44
An Alternative Corporate Governance System
! Germany and Japan developed a different mechanism for corporate
governance, based upon corporate cross holdings.
In Germany, the banks form the core of this system.
In Japan, it is the keiretsus
Other Asian countries have modeled their system after Japan, with family
companies forming the core of the new corporate families
! At their best, the most efcient rms in the group work at bringing the less
efcient rms up to par. They provide a corporate welfare system that makes
for a more stable corporate structure
! At their worst, the least efcient and poorly run rms in the group pull down
the most efcient and best run rms down. The nature of the cross holdings
makes its very difcult for outsiders (including investors in these rms) to
gure out how well or badly the group is doing.
In the 1980s, Michael Porter argued that US companies should move towards
the Japanese system. The Japanese and German systems tend to do well in
stable environments, where failure tends to be unsystematic ( a rm here and a
rm there). They can take care of their failures and nurse them back to health,
rather than exposing themselves to the costs associated with failure.
These systems break down when problems are wide spread and systematic.
Contrast the way US banks dealt with problem loans on their balance sheets
(markets forced them to deal with these problems quickly ) and the way
Japanese banks have dealt with them (by hiding them and hoping they go away)
Aswath Damodaran 45
Choose a Different Objective Function
! Firms can always focus on a different objective function. Examples would
include
maximizing earnings
maximizing revenues
maximizing rm size
maximizing market share
maximizing EVA
! The key thing to remember is that these are intermediate objective functions.
To the degree that they are correlated with the long term health and value of the
company, they work well.
To the degree that they do not, the rm can end up with a disaster
Consider each of these objectives. If you put them through the same tests that
we did stock price maximization, you come up with far more problems with each.
Note that rms might pick an intermediate objective (like market share) when it
is correlated with rm value but continue to use it, even after it loses this link.
Do you want a 100% market share of a losing business?
Aswath Damodaran 46
Maximize Stock Price, subject to ..
! The strength of the stock price maximization objective function is its internal
self correction mechanism. Excesses on any of the linkages lead, if
unregulated, to counter actions which reduce or eliminate these excesses
! In the context of our discussion,
managers taking advantage of stockholders has lead to a much more active market
for corporate control.
stockholders taking advantage of bondholders has lead to bondholders protecting
themselves at the time of the issue.
rms revealing incorrect or delayed information to markets has lead to markets
becoming more skeptical and punitive
rms creating social costs has lead to more regulations, as well as investor and
customer backlashes.
The strength of market based systems is that they are both ruthless and quick in
correcting errors, once they are spotted.
These constraints ow from the earlier framework, where we introduced what
can go wrong with each linkage.
Aswath Damodaran 47
The Stockholder Backlash
! Institutional investors such as Calpers and the Lens Funds have become much
more active in monitoring companies that they invest in and demanding
changes in the way in which business is done
! Individuals like Michael Price specialize in taking large positions in
companies which they feel need to change their ways (Chase, Dow Jones,
Readers Digest) and push for change
! At annual meetings, stockholders have taken to expressing their displeasure
with incumbent management by voting against their compensation contracts
or their board of directors
All of these developments represent the backlash to managers putting their
interests over stockholder interests.
Aswath Damodaran 48
In response, boards are becoming more independent
! Boards have become smaller over time. The median size of a board of
directors has decreased from 16 to 20 in the 1970s to between 9 and 11 in
1998. The smaller boards are less unwieldy and more effective than the larger
boards.
! There are fewer insiders on the board. In contrast to the 6 or more insiders
that many boards had in the 1970s, only two directors in most boards in 1998
were insiders.
! Directors are increasingly compensated with stock and options in the
company, instead of cash. In 1973, only 4% of directors received
compensation in the form of stock or options, whereas 78% did so in 1998.
! More directors are identied and selected by a nominating committee rather
than being chosen by the CEO of the rm. In 1998, 75% of boards had
nominating committees; the comparable statistic in 1973 was 2%.
While these trends are positive, note that many of these better boards (at least as
seen from the vantage point of 1998) were responsible for the scandals of the
bull market (Enron, Worldcom, Tyco) In bull markets and strong economies,
boards tend to get lazy.
Aswath Damodaran 49
Disneys Board in 2003
Board Members Occupation
Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo ODonovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.
Some improvement over 1997 but most of the directors are still there
The most obvious conict (Irwin Russell) has been removed. Still, there are far
too many directors on this board (16), too many of them are still insiders (4)
and there are too many CEOs of other rms. Nevertheless, this board is a
much better one than the 1997 board. What precipitated the changes?
1. Poor nancial and stock price performance
2. Pressure from major stockholders (like Stanley Gold)
3. Stockholder distrust of management
4. Big deals (like the Cap Cities acquisition) that have gone bad
5. Enronitis
Aswath Damodaran 50
Changes in corporate governance at Disney
! Required at least two executive sessions of the board, without the CEO or other members of
management present, each year.
! Created the position of non-management presiding director, and appointed Senator George Mitchell
to lead those executive sessions and assist in setting the work agenda of the board.
! Adopted a new and more rigorous denition of director independence.
! Required that a substantial majority of the board be comprised of directors meeting the new
independence standards.
! Provided for a reduction in committee size and the rotation of committee and chairmanship
assignments among independent directors.
! Added new provisions for management succession planning and evaluations of both management
and board performance
! Provided for enhanced continuing education and training for board members.
These changes were all welcome but they were being made in response to
widespread stockholder anger. They would have been more effective and
believable if they had been adopted at the height of Eisners powers (say, in
1996).
Aswath Damodaran 51
The Hostile Acquisition Threat
! The typical target rm in a hostile takeover has
a return on equity almost 5% lower than its peer group
had a stock that has signicantly under performed the peer group over the previous
2 years
has managers who hold little or no stock in the rm
! In other words, the best defense against a hostile takeover is to run your rm
well and earn good returns for your stockholders
! Conversely, when you do not allow hostile takeovers, this is the rm that you
are most likely protecting (and not a well run or well managed rm)
This is the ultimate threat. Managers often have deathbed conversions to become
advocates for stockholder wealth maximization, when faced with the threat of a
hostile takeover.
For Disney, this wake-up call came in 2004, when Comcast announced a hostile
acquisitiion bid for Disney. Though the bid failed, it shook up the company and
led to Eisners decision to step down in 2006.
Aswath Damodaran 52
Is there a payoff to better corporate governance?
! In the most comprehensive study of the effect of corporate governance on
value, a governance index was created for each of 1500 rms based upon 24
distinct corporate governance provisions.
Buying stocks that had the strongest investor protections while simultaneously
selling shares with the weakest protections generated an annual excess return of
8.5%.
Every one point increase in the index towards fewer investor protections decreased
market value by 8.9% in 1999
Firms that scored high in investor protections also had higher prots, higher sales
growth and made fewer acquisitions.
! The link between the composition of the board of directors and rm value is
weak. Smaller boards do tend to be more effective.
! On a purely anecdotal basis, a common theme at problem companies is an
ineffective board that fails to ask tough questions of an imperial CEO,
The bottom line is this. Changing the way boards of directors are chosen cannot
change the way companies are governed. You need informed and active
stockholders and a responsive management ot make corporate governance work.
When it does, stockholders are better off.
Aswath Damodaran 53
The Bondholders Defense Against Stockholder Excesses
! More restrictive covenants on investment, nancing and dividend policy have
been incorporated into both private lending agreements and into bond issues,
to prevent future Nabiscos.
! New types of bonds have been created to explicitly protect bondholders
against sudden increases in leverage or other actions that increase lender risk
substantially. Two examples of such bonds
Puttable Bonds, where the bondholder can put the bond back to the rm and get
face value, if the rm takes actions that hurt bondholders
Ratings Sensitive Notes, where the interest rate on the notes adjusts to that
appropriate for the rating of the rm
! More hybrid bonds (with an equity component, usually in the form of a
conversion option or warrant) have been used. This allows bondholders to
become equity investors, if they feel it is in their best interests to do so.
Bondholders, responding to the Nabisco asco and other cases where
stockholders expropriated their wealth, have become much more savvy about
protecting themselves (using covenants or special features added to bonds) or
getting an equity stake in the business (as is the case with convertibles)
Aswath Damodaran 54
The Financial Market Response
! While analysts are more likely still to issue buy rather than sell
recommendations, the payoff to uncovering negative news about a rm is
large enough that such news is eagerly sought and quickly revealed (at least to
a limited group of investors).
! As investor access to information improves, it is becoming much more
difcult for rms to control when and how information gets out to markets.
! As option trading has become more common, it has become much easier to
trade on bad news. In the process, it is revealed to the rest of the market.
! When rms mislead markets, the punishment is not only quick but it is
savage.
The distinction between the US and most foreign markets is the existence of a
private market for information. In many countries, rms are the only source of
information about themselves, leading to very biased information.
The more avenues there are for investors to trade on information (including
option markets), the more likely it is that prices will contain that information.
Aswath Damodaran 55
The Societal Response
! If rms consistently out societal norms and create large social costs, the
governmental response (especially in a democracy) is for laws and regulations
to be passed against such behavior.
! For rms catering to a more socially conscious clientele, the failure to meet
societal norms (even if it is legal) can lead to loss of business and value
! Finally, investors may choose not to invest in stocks of rms that they view as
social outcasts.
None of these measures is perfect or complete, but they reect the tug-of-war
between private and public interests.
Here are some good examples for each:
1. After the Exxon-Valdez oil spill in the alter 1980s, many states and the
federal government tightened regulations on oil tankers The same is true
for tobacco rms, where laws were tightened both on smoking in general
and tobacco company advertising in particular.
2. After public interest groups claimed that speciality retailers were using
under-age labor to run their factories, many retailers saw sales decline.
3. Many pension funds (and university endowment funds) are restricted from
iinvesting in sin stocks.
Aswath Damodaran 56
The Counter Reaction
STOCKHOLDERS
Managers of poorly
run rms are put
on notice.
1. More activist
investors
2. Hostile takeovers
BONDHOLDERS
Protect themselves
1. Covenants
2. New Types
FINANCIAL MARKETS
SOCIETY Managers
Firms are
punished
for misleading
markets
Investors and
analysts become
more skeptical
Corporate Good Citizen Constraints
1. More laws
2. Investor/Customer Backlash
This summarizes the objective function of maximizing stockholder wealth, with
the xes noted on the last few pages.
Aswath Damodaran 57
So what do you think?
! At this point in time, the following statement best describes where I stand in
terms of the right objective function for decision making in a business
a) Maximize stock price or stockholder wealth, with no constraints
b) Maximize stock price or stockholder wealth, with constraints on being a good
social citizen.
c) Maximize prots or protability
d) Maximize market share
e) Maximize Revenues
f) Maximize social good
g) None of the above
If the sales pitch has worked, most choose to maximize stock price, subject to
constraint. If it has not, you have a long semester ahead of you.
In reasonably efcient markets, where bondholders and lenders are protected,
stock prices are maximized where rm value is maximized. Thus, these objective
functions become equivalent.
Aswath Damodaran 58
The Modied Objective Function
! For publicly traded rms in reasonably efcient markets, where bondholders
(lenders) are protected:
Maximize Stock Price: This will also maximize rm value
! For publicly traded rms in inefcient markets, where bondholders are
protected:
Maximize stockholder wealth: This will also maximize rm value, but might not
maximize the stock price
! For publicly traded rms in inefcient markets, where bondholders are not
fully protected
Maximize rm value, though stockholder wealth and stock prices may not be
maximized at the same point.
! For private rms, maximize stockholder wealth (if lenders are protected) or
rm value (if they are not)
These are the guiding objectives that we will use. For the publicly traded rms in
our analysis, we will view maximizing stock prices as our objective function (but
in the context of efcient markets and protected lenders). For the private rm, we
will focus on maximizing stockholder wealth.
Aswath Damodaran 59
Risk and Return Models: Equity and Debt
The rst and perhaps biggest part of corporate nance.
The focus of the rst part of this investment analysis section is on coming up
with a minimum acceptable hurdle rate. In the process, we have to grapple with
the question of what risk is and how to bring risk into the hurdle rate.
Aswath Damodaran 60
First Principles
! Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
The hurdle rate should be higher for riskier projects and reect the nancing
mix used - owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash ows generated and the
timing of these cash ows; they should also consider both positive and negative
side effects of these projects.
! Choose a nancing mix that minimizes the hurdle rate and matches the assets
being nanced.
! If there are not enough investments that earn the hurdle rate, return the cash to
stockholders.
The form of returns - dividends and stock buybacks - will depend upon the
stockholders characteristics.
Aswath Damodaran 61
The notion of a benchmark
! Since nancial resources are nite, there is a hurdle that projects have to cross
before being deemed acceptable.
! This hurdle will be higher for riskier projects than for safer projects.
! A simple representation of the hurdle rate is as follows:
Hurdle rate = Riskless Rate + Risk Premium
! The two basic questions that every risk and return model in nance tries to
answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?
Underlying the idea of a hurdle rate is the notion that projects have to earn a
benchmark rate of return to be accepted, and that this benchmark should be
higher for riskier projects than for safer ones.
Aswath Damodaran 62
What is Risk?
! Risk, in traditional terms, is viewed as a negative. Websters dictionary, for
instance, denes risk as exposing to danger or hazard. The Chinese symbols
for risk, reproduced below, give a much better description of risk
! The rst symbol is the symbol for danger, while the second is the symbol
for opportunity, making risk a mix of danger and opportunity.
Note that risk is neither good nor bad. It is a combination of danger and
opportunity - you cannot have one without the other.
When businesses want opportunity (higher returns), they have to live with the
higher risk.
Any sales pitch that offers returns without risk is a pipe dream.
Aswath Damodaran 63
A good risk and return model should
1. It should come up with a measure of risk that applies to all assets and not be
asset-specic.
2. It should clearly delineate what types of risk are rewarded and what are not,
and provide a rationale for the delineation.
3. It should come up with standardized risk measures, i.e., an investor presented
with a risk measure for an individual asset should be able to draw conclusions
about whether the asset is above-average or below-average risk.
4. It should translate the measure of risk into a rate of return that the investor
should demand as compensation for bearing the risk.
5. It should work well not only at explaining past returns, but also in predicting
future expected returns.
Before we embark on looking at risk and return models, it pays to specify what
a good model will look like
Aswath Damodaran 64
The Capital Asset Pricing Model
! Uses variance of actual returns around an expected return as a measure of risk.
! Species that a portion of variance can be diversied away, and that is only
the non-diversiable portion that is rewarded.
! Measures the non-diversiable risk with beta, which is standardized around
one.
! Translates beta into expected return -
Expected Return = Riskfree rate + Beta * Risk Premium
! Works as well as the next best alternative in most cases.
This is a summary of the CAPM, before we get into the details.
Aswath Damodaran 65
The Mean-Variance Framework
! The variance on any investment measures the disparity between actual and
expected returns.
Expected Return
Low Variance Investment
High Variance Investment
Note that the variance that the CAPM is built around is the variance of actual
returns around an expected return.
If you were an investor with a 1-year time horizon, and you bought a 1-
year T.Bill, your actual returns (at least in nominal terms) will be equal
to your expected returns.
If you were the same investor, and you bought a stock (say Intel), your
actual returns will almost certainly not be equal to your expected returns.
In practice, we often look at historical (past) returns to estimate variances.
Implicitly, we are assuming that this variance is a good proxy for expected
future variance.
Aswath Damodaran 66
How risky is Disney? A look at the past
Figure 3.4: Returns on Disney: 1999- 2003
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
F
e
b
-
9
9
A
p
r
-
9
9
J
u
n
-
9
9
A
u
g
-
9
9
O
c
t-
9
9
D
e
c
-
9
9
F
e
b
-
0
0
A
p
r
-
0
0
J
u
n
-
0
0
A
u
g
-
0
0
O
c
t-
0
0
D
e
c
-
0
0
F
e
b
-
0
1
A
p
r
-
0
1
J
u
n
-
0
1
A
u
g
-
0
1
O
c
t-
0
1
D
e
c
-
0
1
F
e
b
-
0
2
A
p
r
-
0
2
J
u
n
-
0
2
A
u
g
-
0
2
O
c
t-
0
2
D
e
c
-
0
2
F
e
b
-
0
3
A
p
r
-
0
3
J
u
n
-
0
3
A
u
g
-
0
3
O
c
t-
0
3
D
e
c
-
0
3
Month
R
e
tu
r
n
o
n
D
is
n
e
y
(
in
c
lu
d
in
g
d
iv
id
e
n
d
s
)
Disneys stock price has been volatile, yielding a standard deviation of 32.31%
(on an annualized basis) between 19999 and 2003. If you were an investor
looking at Disney in 2004, what concerns (if any) would you have in using this
as your measure of the forward looking risk in Disney stock?
Aswath Damodaran 67
Do you live in a mean-variance world?
! Assume that you had to pick between two investments. They have the same
expected return of 15% and the same standard deviation of 25%; however,
investment A offers a very small possibility that you could quadruple your
money, while investment Bs highest possible payoff is a 60% return. Would
you
a. be indifferent between the two investments, since they have the same expected
return and standard deviation?
b. prefer investment A, because of the possibility of a high payoff?
c. prefer investment B, because it is safer?
While some people may be indifferent, most pick investment A. The possibility
of a high payoff, even though it is captured in the expected value, seems to tilt
investors. In statistical terms, this can be viewed as evidence that investors prefer
positive skewness (high positive payoffs) and value it. It is a direct contradiction
to the mean-variance framework that underlies so much of conventional risk
theory.
Aswath Damodaran 68
The Importance of Diversication: Risk Types
Actions/Risk that
affect only one
firm
Actions/Risk that
affect all investments
Firm-specific Market
Projects may
do better or
worse than
expected
Competition
may be stronger
or weaker than
anticipated
Entire Sector
may be affected
by action
Exchange rate
and Political
risk
Interest rate,
Inflation &
news about
economy
Figure 3.5: A Break Down of Risk
Affects few
firms
Affects many
firms
Firm can
reduce by
Investing in lots
of projects
Acquiring
competitors
Diversifying
across sectors
Diversifying
across countries
Cannot affect
Investors
can
mitigate by
Diversifying across domestic stocks Diversifying across
asset classes
Diversifying globally
This is the critical second step that all risk and return models in nance take.
As examples,
Project-specic Risk: Disneys new Animal Kingdom theme park: To
the degree that actual revenues at this park may be greater or less than
expected.
Competitive Risk: The competition (Universal Studios, for instance) may
take actions (like opening or closing a park) that affect Disneys
revenues at Animal Kingdom.
Industry-specic risk: Congress may pass laws affecting cable and
network television, and affect expected revenues at Disney and ABC, as
well as all other rms in the sector, perhaps to varying degrees.
International Risk: As the Asian crisis deepened in the late 1990s, there
wasy be a loss of revenues at Disneyland (as tourists from Asia choose
to stay home) and at Tokyo Disney
Market risk: If interest rates in the US go up, Disneys value as a rm
will be affected.
From the perspective of an investor who holds only Disney, all risk is relevant.
From the perspective of a diversied investor, the rst three risks can be
diversied away, the fourth might be diversiable (with a globally diversied
portfolio) but the last risk I not.
Aswath Damodaran 69
The Effects of Diversication
! Firm-specic risk can be reduced, if not eliminated, by increasing the number
of investments in your portfolio (i.e., by being diversied). Market-wide risk
cannot. This can be justied on either economic or statistical grounds.
! On economic grounds, diversifying and holding a larger portfolio eliminates
rm-specic risk for two reasons-
(a) Each investment is a much smaller percentage of the portfolio, muting the effect
(positive or negative) on the overall portfolio.
(b) Firm-specic actions can be either positive or negative. In a large portfolio, it is
argued, these effects will average out to zero. (For every rm, where something
bad happens, there will be some other rm, where something good happens.)
The rst argument (that each investment is a small percent of your portfolio) is a
pretty weak one. The second one (that things average out over investments and
time) is a much stronger one.
Consider the news stories in the WSJ on any given day. About 85 to 90% of the
stories are on individual rms (rather than affecting the entire market or about
macro economic occurrences) and they cut both ways - some stories are good
news (with the stock price rising) and some are bad news (with stock prices
falling)
Aswath Damodaran 70
A Statistical Proof that Diversication works An example
with two stocks..
Disney Aracruz
ADR
Average Monthly Return - 0.07% 2.57%
Standard Deviation in Monthly Returns 9.33% 12.62%
Correlation between Disney and Aracruz 0.2665
These are the statistics for Disney and Aracruz from 1999 to 2003. They are
annualized values computed from monthly returns.
Aswath Damodaran 71
The variance of a portfolio
Figure 3.6: Standard Deviation of Portfolio
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
100% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%
Proportion invested in Disney
S
ta
n
d
a
r
d
d
e
v
ia
tio
n
o
f
p
o
r
tf
o
lio
As you combine Disney and Aracruz in a portfolio, the variance declines
(because the correlation between the stocks is low) and is actually minimized at
about 70% Disney, 30% Aracruz
The gains would have been even stronger if the correlation had been zero or
negative. Even when two stocks move together though (the correlation is
positive but not one), there will be gains from diversication.
Aswath Damodaran 72
The Role of the Marginal Investor
! The marginal investor in a rm is the investor who is most likely to be the
buyer or seller on the next trade and to inuence the stock price.
! Generally speaking, the marginal investor in a stock has to own a lot of stock
and also trade a lot.
! Since trading is required, the largest investor may not be the marginal
investor, especially if he or she is a founder/manager of the rm (Michael
Dell at Dell Computers or Bill Gates at Microsoft)
! In all risk and return models in nance, we assume that the marginal investor
is well diversied.
We assume that the marginal investor, who sets prices, is well diversied. (Note
that we do not need to assume that all investors are diversied)
An argument for the marginally diversied investor: Assume that a
diversied investor and a non-diversied investor are both looking at Disney.
The latter looks at the stock and sees all risk. The former looks at it and sees
only the non-diversiable risk. If they agree on the expected earnings and cash
ows, the former will be willing to pay a higher price. Thus, the latter will get
driven out of the market (perhaps into mutual funds).
Aswath Damodaran 73
Identifying the Marginal Investor in your rm
Percent of Stock held by
Institutions
Percent of Stock held by
Insiders
Marginal Investor
High Low Institutional Investor
a
High High Institutional Investor, with
insider influence
Low High (held by
founder/manager of firm)
Insider (often undiversified)
Low High (held by wealthy
individual investor)
Wealthy individual
investor, fairly diversified
Low Low Small individual investor
with restricted
diversification
This is meant to be a rough guide to identifying the marginal investor. The key
is to recognize that you are not identifying a particular investor but a type of
investor.
Aswath Damodaran 74
Looking at Disneys top stockholders (again)
Of Disneys top 17 investors, only 1 is an individual.
Aswath Damodaran 75
And the top investors in Deutsche and Aracruz
Deutsche Bank Aracruz - Preferred
Allianz (4.81%) Safra (10.74%)
La Caixa (3.85%) BNDES (6.34%)
Capital Research (1.35%) Scudder Kemper (1.03%)
Fidelity (0.50%) BNP Paribas (0.56%)
Frankfurt Trust (0.43%) Barclays Global (0.29%)
Aviva (0.37%) Vanguard Group (0.18%)
Daxex (0.31%) Banco Itau (0.12%)
Unifonds (0.29%) Van Eck Associates (0.12%)
Fidelity (0.28%) Pactual (0.11%)
UBS Funds (0.21%) Banco Bradesco (0.07%)
The top investors are also institutional investors.
Aswath Damodaran 76
Analyzing the investor bases
Disney Deutsche Bank Aracruz (non-voting)
Mutual Funds 31% 16% 29%
Other
Institutional
Investors
42% 58% 26%
Individuals 27% 26% 45%
These companies are predominantly held by institutions who also do much of
the trading on the stock. Insiders hold almost no stock in the company. The
marginal investor is an institutional investor. Aracruz has the highest
percentage of individual investors and it also has voting shares held by insiders.
We would be most cautious in extending the marginal investor is diversied
argument to Aracruz.
Aswath Damodaran 77
The Market Portfolio
! Assuming diversication costs nothing (in terms of transactions costs), and
that all assets can be traded, the limit of diversication is to hold a portfolio of
every single asset in the economy (in proportion to market value). This
portfolio is called the market portfolio.
! Individual investors will adjust for risk, by adjusting their allocations to this
market portfolio and a riskless asset (such as a T-Bill)
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio
! Every investor holds some combination of the risk free asset and the market
portfolio.
There are two reasons investors choose to stay undiversied:
They think that they can pick undervalued investments (private
information)
There are transactions costs. Since the marginal benets of
diversication decrease as the number of investments increases, you will
stop diversifying.
If we assume no costs to diversifying and no private information, we take away
these reasons fro not diversifying. Consequently, you will keep adding traded
assets to your portfolio until you have every single one. This portfolio is called
the market portfolio. This portfolio should include all traded assets, held in
proportion to their market value.
The only differences between investors then will be in not what is in the market
portfolio but how much they allocate to the riskless asset and how much to the
market portfolio.
Aswath Damodaran 78
The Risk of an Individual Asset
! The risk of any asset is the risk that it adds to the market portfolio
Statistically, this risk can be measured by how much an asset moves with the
market (called the covariance)
! Beta is a standardized measure of this covariance, obtained by dividing the
covariance of any asset with the market by the variance of the market. It is a
measure of the non-diversiable risk for any asset can be measured by the
covariance of its returns with returns on a market index, which is dened to
be the asset's beta.
! The required return on an investment will be a linear function of its beta:
Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio -
Riskfree Rate)
If an investor holds the market portfolio, the risk of any asset is the risk that it
adds to the portfolio. That is what beta measures.
The cost of equity is a linear function of the beta of the portfolio.
Aswath Damodaran 79
Limitations of the CAPM
1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated precisely
- Denition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be
a linear relationship between returns and betas
the only variable that should explain returns is betas
- The reality is that
the relationship between betas and returns is weak
Other variables (size, price/book value) seem to explain differences in returns better.
The rst two critiques can be lowered against any model in nance.
The last critique is the most damaging. Fama and French (1991) noted that
Betas explained little of the difference in returns across stocks between
1962 and 1991. (Over long time periods, it should, if the CAPM is right
and betas are correctly estimated), explain almost all of the difference)
Market Capitalization and price to book value ratios explained a
signicant portion of the differences in returns.
This test, however, is a test of which model explains past returns best,
and might not necessarily be a good indication of which one is the best
model for predicting expected returns in the future.
Aswath Damodaran 80
Alternatives to the CAPM
The risk in an investment can be measured by the variance in actual returns around an
expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy Models
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Beta of asset relative to
Market portfolio (from
a regression)
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.
Betas of assets relative
to specified macro
economic factors (from
a regression)
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
Note that all of the models of risk and return in nance agree on the rst two
steps. They deviate at the last step in the way they measure market risk, with
The CAPM, capturing all of it in one beta, relative to the market portfolio
The APM, capturing the market risk in multiple betas against unspecied
economic factors
The Multi-Factor model, capturing the market risk in multiple betas
against specied macro economic factors
The Regression model, capturing the market risk in proxies such as
market capitalization and price/book ratios
Aswath Damodaran 81
Why the CAPM persists
! The CAPM, notwithstanding its many critics and limitations, has survived as
the default model for risk in equity valuation and corporate nance. The
alternative models that have been presented as better models (APM,
Multifactor model..) have made inroads in performance evaluation but not in
prospective analysis because:
The alternative models (which are richer) do a much better job than the CAPM in
explaining past return, but their effectiveness drops off when it comes to
estimating expected future returns (because the models tend to shift and change).
The alternative models are more complicated and require more information than
the CAPM.
For most companies, the expected returns you get with the the alternative models
is not different enough to be worth the extra trouble of estimating four additional
betas.
It takes a model to beat a model The CAPM may not be a very good model at
predicting expected returns but the alternative models dont do much better
either. In fact, the tests of the CAPM are joint tests of both the effectiveness of
the model and the quality of the parameters used in the testing (betas, for
instance). We will argue that better beta estimates and a more careful use of the
CAPM can yield far better estimates of expected return than switching to a
different model.
Aswath Damodaran 82
!Application Test: Who is the marginal investor in your
rm?
You can get information on insider and institutional holdings in your rm from:
http://nance.yahoo.com/
Enter your companys symbol and choose prole.
! Looking at the breakdown of stockholders in your rm, consider whether the
marginal investor is
a) An institutional investor
b) An individual investor
c) An insider
For most large US rms, most, if not all, of the 15 largest investors are
institutional investors. Thus, the assumption that the marginal investor is well
diversied is quite justiable.
For very small rms, the marginal investor may be an individual investor or even
a day trader, who is not diversied. What implications does this have for the use
of risk and return models?
Aswath Damodaran 83
Estimating Hurdle Rates: Risk Parameters
Aswath Damodaran 84
Inputs required to use the CAPM -
" The capital asset pricing model yields the following expected return:
Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio -
Riskfree Rate)
To use the model we need three inputs:
(a) The current risk-free rate
(b) The expected market risk premium (the premium expected for investing in risky
assets (market portfolio) over the riskless asset)
(c) The beta of the asset being analyzed.
Summarizes the inputs. Note that we are replacing the last component (E(Rm)-
Rf) with the expected risk premium..
Aswath Damodaran 85
The Riskfree Rate and Time Horizon
! On a riskfree asset, the actual return is equal to the expected return. Therefore,
there is no variance around the expected return.
! For an investment to be riskfree, i.e., to have an actual return be equal to the
expected return, two conditions have to be met
There has to be no default risk, which generally implies that the security has to be
issued by the government. Note, however, that not all governments can be viewed
as default free.
There can be no uncertainty about reinvestment rates, which implies that it is a
zero coupon security with the same maturity as the cash ow being analyzed.
Reemphasize that you need to know the expected returns with certainty for
something to be riskless.
No default risk and no reinvestment risk. Most people understand the rst point,
but dont get the second.
If you need an investment where you will know the expected returns with
certainty over a 5-year time horizon, what would that investment be?
A T.Bill would not work - there is reinvestment risk.
Even a 5-year T.Bond would not work, because the coupons will cause
the actual return to deviate from the expected return.
Thus, you need a 5-year zero coupon T.Bond
Aswath Damodaran 86
Riskfree Rate in Practice
! The riskfree rate is the rate on a zero coupon government bond matching the
time horizon of the cash ow being analyzed.
! Theoretically, this translates into using different riskfree rates for each cash
ow - the 1 year zero coupon rate for the cash ow in year 1, the 2-year zero
coupon rate for the cash ow in year 2 ...
! Practically speaking, if there is substantial uncertainty about expected cash
ows, the present value effect of using time varying riskfree rates is small
enough that it may not be worth it.
From a present value standpoint, using different riskfree rates for each cash
ow may be overkill, except in those cases where your interest rates are very
different for different time horizons (a very upward sloping or downward
sloping yield curve)
Aswath Damodaran 87
The Bottom Line on Riskfree Rates
! Using a long term government rate (even on a coupon bond) as the riskfree
rate on all of the cash ows in a long term analysis will yield a close
approximation of the true value.
! For short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.
! The riskfree rate that you use in an analysis should be in the same currency
that your cashows are estimated in. In other words, if your cashows are in
U.S. dollars, your riskfree rate has to be in U.S. dollars as well.
Data Source: You can get riskfree rates for the US in a number of sites. Try
http://www.bloomberg.com/markets.
Since corporate nance generally looks at long term decisions, we will for the
most part use the long term government bond rate.
Aswath Damodaran 88
What if there is no default-free entity?
! You could adjust the local currency government borrowing rate by the
estimated default spread on the bond to arrive at a riskless local currency rate.
The default spread on the government bond can be estimated using the local
currency ratings that are available for many countries.
! For instance, assume that the Brazilian government bond rate (in nominal
Brazilian Reals (BR)) is 14% and that the local currency rating assigned to the
Brazilian government is BB+. If the default spread for BB+ rated bonds is
5%, the riskless Brazilian real rate would be 9%.
! Alternatively, you can analyze Brazilian companies in U.S. dollars and use a
treasury bond rate as your riskfree rate or in real terms and do all analysis
without an ination component.
For a real riskfree rate, an expected real growth rate for the economy should
provide a reasonable approximation.
To do your analysis in real terms, you need a real riskfree rate. In the
U.S., you can obtain such a rate by looking at the ination indexed
treasury bond rate. Outside the U.S., you can assume as a rough
approximation that the real riskfree rate is equal to your real growth rate.
IIf the real growth rate is much lower than the real interest rate, you will
have signicant decits - trade or budget - to make up the shortfall. If the
real growth rate is much higher than the real interest rate, you will the
exact opposite - surpluses. A long term equilibrium can be reached only
when the two are equal.
Aswath Damodaran 89
Measurement of the risk premium
! The risk premium is the premium that investors demand for investing in an
average risk investment, relative to the riskfree rate.
! As a general proposition, this premium should be
greater than zero
increase with the risk aversion of the investors in that market
increase with the riskiness of the average risk investment
Implicit here are two questions - Which investors risk premium? What is the
average risk investment?
Aswath Damodaran 90
What is your risk premium?
! Assume that stocks are the only risky assets and that you are offered two investment options:
a riskless investment (say a Government Security), on which you can make 5%
a mutual fund of all stocks, on which the returns are uncertain
How much of an expected return would you demand to shift your money from the riskless asset to the
mutual fund?
a) Less than 5%
b) Between 5 - 7%
c) Between 7 - 9%
d) Between 9 - 11%
e) Between 11- 13%
f) More than 13%
Check your premium against the survey premium on my web site.
I usually nd that the median number that I get in the US is 10.7-12.7%, though
the distribution is pretty spread out. This translates into a risk premium of 4-6%.
Aswath Damodaran 91
Risk Aversion and Risk Premiums
! If this were the capital market line, the risk premium would be a weighted
average of the risk premiums demanded by each and every investor.
! The weights will be determined by the magnitude of wealth that each investor
has. Thus, Warren Buffets risk aversion counts more towards determining
the equilibrium premium than yours and mine.
! As investors become more risk averse, you would expect the equilibrium
premium to increase.
The wealthier you are, the more your estimate of the risk premium will weight
into the nal market premium.
Aswath Damodaran 92
Risk Premiums do change..
Go back to the previous example. Assume now that you are making the same
choice but that you are making it in the aftermath of a stock market crash (it
has dropped 25% in the last month). Would you change your answer?
a) I would demand a larger premium
b) I would demand a smaller premium
c) I would demand the same premium
Quite a few will demand a larger premium, suggesting that this is a dynamic
estimate, changing from period to period.
You can ask the same question about how a recession or losing your job will
affect your risk premium.
Aswath Damodaran 93
Estimating Risk Premiums in Practice
! Survey investors on their desired risk premiums and use the average premium
from these surveys.
! Assume that the actual premium delivered over long time periods is equal to
the expected premium - i.e., use historical data
! Estimate the implied premium in todays asset prices.
Lists the basic approaches
Aswath Damodaran 94
The Survey Approach
! Surveying all investors in a market place is impractical.
! However, you can survey a few investors (especially the larger investors) and
use these results. In practice, this translates into surveys of money managers
expectations of expected returns on stocks over the next year.
! The limitations of this approach are:
there are no constraints on reasonability (the survey could produce negative risk
premiums or risk premiums of 50%)
they are extremely volatile
they tend to be short term; even the longest surveys do not go beyond one year
Merrill Lynch does surveys of portfolio managers (who presumably have more
wealth to invest and hence should be weighted more) asking investors what they
think the market will do over the next year. They report the number but do not
use it internally as a risk premium.
Aswath Damodaran 95
The Historical Premium Approach
! This is the default approach used by most to arrive at the premium to use in
the model
! In most cases, this approach does the following
it denes a time period for the estimation (1926-Present, 1962-Present....)
it calculates average returns on a stock index during the period
it calculates average returns on a riskless security over the period
it calculates the difference between the two
and uses it as a premium looking forward
! The limitations of this approach are:
it assumes that the risk aversion of investors has not changed in a systematic way
across time. (The risk aversion may change from year to year, but it reverts back to
historical averages)
it assumes that the riskiness of the risky portfolio (stock index) has not changed
in a systematic way across time.
This is the basic approach used by almost every large investment bank and
consulting rm.
Aswath Damodaran 96
Historical Average Premiums for the United States
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period T.Bills T.Bonds T.Bills T.Bonds
1928-2004 7.92% 6.53% 6.02% 4.84%
1964-2004 5.82% 4.34% 4.59% 3.47%
1994-2004 8.60% 5.82% 6.85% 4.51%
What is the right premium?
! Go back as far as you can. Otherwise, the standard error in the estimate will be large. (
! Be consistent in your use of a riskfree rate.
! Use arithmetic premiums for one-year estimates of costs of equity and geometric premiums for estimates of long term
costs of equity.
Data Source: Check out the returns by year and estimate your own historical premiums by going to updated data on my web
site.
!
Std Error in estimate =
Annualized Std deviation in Stock prices
Number of years of historical data
)
This is based upon historical data available on the Federal Reserve site in St.
Louis. There are three reasons for why the premium estimated may differ:
1. How far back you go (My personal bias is to go back as far as
possible. Stock prices are so noisy that you need very long time periods
to get reasonable estimates)
2. Whether you use T.Bill or T.Bond rates ( You have to be consistent.
Since I will be using the T.Bond rate as my riskfree rate, I will use the
premium over that rate)
3. Whether you use arithmetic or geometric means (If returns were
uncorrelated over time, and you were asked to estimate a 1-year
premium, the arithmetic mean would be used. Since returns are
negatively correlated over time, and we are estimating premiums over
longer holding periods, it makes more sense to use the compounded
return, which gives us the geometric average)
Thus, I should be using the updated geometric average for stocks over bonds.
The rest of these lecture notes were set in 2004, and the risk premiums used will
reect risk premiums then:
Aswath Damodaran 97
What about historical premiums for other markets?
! Historical data for markets outside the United States is available for much
shorter time periods. The problem is even greater in emerging markets.
! The historical premiums that emerge from this data reects this and there is
much greater error associated with the estimates of the premiums.
Increasingly, the challenges we face are in estimating risk premiums outside the
United States, not only because so many companies that we value are in
younger, emerging markets but because so many US companies are looking at
expanding into these markets.
Aswath Damodaran 98
One solution: Look at a countrys bond rating and default
spreads as a start
! Ratings agencies such as S&P and Moodys assign ratings to countries that
reect their assessment of the default risk of these countries. These ratings
reect the political and economic stability of these countries and thus provide
a useful measure of country risk. In September 2004, for instance, Brazil had
a country rating of B2.
! If a country issues bonds denominated in a different currency (say dollars or
euros), you can also see how the bond market views the risk in that country.
In September 2004, Brazil had dollar denominated C-Bonds, trading at an
interest rate of 10.01%. The US treasury bond rate that day was 4%, yielding
a default spread of 6.01% for Brazil.
! Many analysts add this default spread to the US risk premium to come up
with a risk premium for a country. Using this approach would yield a risk
premium of 10.85% for Brazil, if we use 4.84% as the premium for the US.
This appraoch is simple but it assumes that country default spreads are also
good measures of additional country equity risk. The question thought is
whether equities (which are riskier than bonds) should command a larger risk
premium.
Aswath Damodaran 99
Beyond the default spread
! Country ratings measure default risk. While default risk premiums and equity
risk premiums are highly correlated, one would expect equity spreads to be
higher than debt spreads. If we can compute how much more risky the equity
market is, relative to the bond market, we could use this information. For
example,
Standard Deviation in Bovespa (Equity) = 36%
Standard Deviation in Brazil C-Bond = 28.2%
Default spread on C-Bond = 6.01%
Country Risk Premium for Brazil = 6.01% (36%/28.2%) = 7.67%
! Note that this is on top of the premium you estimate for a mature market.
Thus, if you assume that the risk premium in the US is 4.84%, the risk
premium for Brazil would be 12.51%.
In In this approach, we scale up the default spread to reect the additional risk in
stocks This will result in larger equity risk premiums. There is a third
approach which is closely related where you look at the standard deviation of the
emerging equity market, relative to the standard deviation of the U.S. equity
market, and multiply by the U.S. equity risk premium. Thus, the equity risk
premium for an emerging market which is twice as volatiles as the the US
market should have an equity risk premium of 9.68% (twice 4.84%).
Aswath Damodaran 100
Implied Equity Premiums
! We can use the information in stock prices to back out how risk averse the market is and how much of a risk premium it
is demanding.
! If you pay the current level of the index, you can expect to make a return of 7.87% on stocks (which is obtained by
solving for r in the following equation)
! Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.87% - 4.22% = 3.65%
!
1211.92 =
38.13
(1+ r)
+
41.37
(1+ r)
2
+
44.89
(1+ r)
3
+
48.71
(1+ r)
4
+
52.85
(1+ r)
5
+
52.85(1.0422)
(r ".0422)(1+ r)
5
January 1, 2005
S&P 500 is at 1211.92
In 2004, dividends & stock
buybacks were 2.90% of
the index, generating 35.15
in cashflows
Analysts expect earnings to grow 8.5% a year for the next 5 years .
After year 5, we will assume that
earnings on the index will grow at
4.22%, the same rate as the entire
economy
38.13 41.37 44.89 48.71 52.85
Aswath Damodaran 101
Implied Premiums in the US
Aswath Damodaran 102
! Application Test: A Market Risk Premium
! Based upon our discussion of historical risk premiums so far, the risk
premium looking forward should be:
a) About 7.92%, which is what the arithmetic average premium has been since 1928,
for stocks over T.Bills
b) About 4.84%, which is the geometric average premium since 1928, for stocks
over T.Bonds
c) About 3.7%, which is the implied premium in the stock market today
There is no right answer, but it will lead to very different costs of equity and
capital, and corporate nancial decisions down the road.
Aswath Damodaran 103
Estimating Beta
! The standard procedure for estimating betas is to regress stock returns (R
j
)
against market returns (R
m
) -
R
j
= a + b R
m
where a is the intercept and b is the slope of the regression.
! The slope of the regression corresponds to the beta of the stock, and measures
the riskiness of the stock.
Betas reect not just the volatility of the underlying investment but also how it
moves with the market:
Beta (Slope) = Correlation
jm
(!
j /
!
m
)
Note that !
j
can be high but beta can be low (because the asset is not very
highly correlated with the market)
Aswath Damodaran 104
Estimating Performance
! The intercept of the regression provides a simple measure of performance
during the period of the regression, relative to the capital asset pricing model.
R
j
= R
f
+ b (R
m
- R
f
)
= R
f
(1-b) + b R
m
........... Capital Asset Pricing Model
R
j
= a + b R
m
........... Regression Equation
! If
a > R
f
(1-b) .... Stock did better than expected during regression period
a = R
f
(1-b) .... Stock did as well as expected during regression period
a < R
f
(1-b) .... Stock did worse than expected during regression period
! The difference between the intercept and R
f
(1-b) is Jensen's alpha. If it is
positive, your stock did perform better than expected during the period of the
regression.
Jensens alpha can also be computed by estimating the expected return during
the period of the regression, using the actual return on the market during the
period, the riskfree rate during the period and the estimated beta, and then
comparing it to the actual return over the period.
Algebraically, you should get the same answer.
Aswath Damodaran 105
Firm Specic and Market Risk
! The R squared (R
2
) of the regression provides an estimate of the proportion
of the risk (variance) of a rm that can be attributed to market risk;
! The balance (1 - R
2
) can be attributed to rm specic risk.
This ties back to the second step of the derivation of the model, where we
divided risk into diversiable and non-diversiable risk. R squared measures the
proportion of the risk that is not diversiable (also called market or systematic
risk)
Aswath Damodaran 106
Setting up for the Estimation
! Decide on an estimation period
Services use periods ranging from 2 to 5 years for the regression
Longer estimation period provides more data, but rms change.
Shorter periods can be affected more easily by signicant rm-specic event that
occurred during the period (Example: ITT for 1995-1997)
! Decide on a return interval - daily, weekly, monthly
Shorter intervals yield more observations, but suffer from more noise.
Noise is created by stocks not trading and biases all betas towards one.
! Estimate returns (including dividends) on stock
Return = (Price
End
- Price
Beginning
+ Dividends
Period
)/ Price
Beginning
Included dividends only in ex-dividend month
! Choose a market index, and estimate returns (inclusive of dividends) on the
index for each interval for the period.
Note the number of subjective judgments that have to be made. The estimated
beta is going to be affected by all these judgments.
My personal biases are to
Use ve years of data (because I use monthly data)
Use monthly returns (to avoid non-trading problems)
Use returns with dividends
Use an index that is broad, market weighted and with a long history (I
use the S&P 500. The NYSE composite is not market weighted, and the
Wilshire 5000 has both non-trading and measurement issues that have
not been resolved.)
Reports parameters used.
Aswath Damodaran 107
Choosing the Parameters: Disney
! Period used: 5 years
! Return Interval = Monthly
! Market Index: S&P 500 Index.
! For instance, to calculate returns on Disney in December 1999,
Price for Disney at end of November 1999 = $ 27.88
Price for Disney at end of December 1999 = $ 29.25
Dividends during month = $0.21 (It was an ex-dividend month)
Return =($29.25 - $27.88 + $ 0.21)/$27.88= 5.69%
! To estimate returns on the index in the same month
Index level (including dividends) at end of November 1999 = 1388.91
Index level (including dividends) at end of December 1999 = 1469.25
Return =(1469.25 - 1388.91)/ 1388.91 = 5.78%
This has both the scatter plot and the regression line. Note the noise in the plots
around the line.
That can be viewed either as a sign of a poor regression or as a measure of the
rm-specic risk that Disney is exposed to.
Aswath Damodaran 108
Disneys Historical Beta
Aswath Damodaran 109
The Regression Output
! Using monthly returns from 1999 to 2003, we ran a regression of returns on
Disney stock against the S*P 500. The output is below:
Returns
Disney
= 0.0467% + 1.01 Returns
S & P 500
(R squared= 29%)
(0.20)
The standard error of the beta is reported in brackets under the beta.
Aswath Damodaran 110
Analyzing Disneys Performance
! Intercept = 0.0467%
This is an intercept based on monthly returns. Thus, it has to be compared to a
monthly riskfree rate.
Between 1999 and 2003,
Monthly Riskfree Rate = 0.313% (based upon average T.Bill rate: 99-03)
Riskfree Rate (1-Beta) = 0.313% (1-1.01) = -..0032%
! The Comparison is then between
Intercept versus Riskfree Rate (1 - Beta)
0.0467% versus 0.313%(1-1.01)=-0.0032%
Jensens Alpha = 0.0467% -(-0.0032%) = 0.05%
! Disney did 0.05% better than expected, per month, between 1999 and 2003.
Annualized, Disneys annual excess return = (1.0005)
12
-1= 0.60%
Disney did 0.60% better than expected on an annual basis between 1999 and
2003.
Aswath Damodaran 111
More on Jensens Alpha
If you did this analysis on every stock listed on an exchange, what would the
average Jensens alpha be across all stocks?
a) Depend upon whether the market went up or down during the period
b) Should be zero
c) Should be greater than zero, because stocks tend to go up more often than down
Should be zero, if it is weighted by market value. The market cannot beat or lag
itself.
Aswath Damodaran 112
A positive Jensens alpha Who is responsible?
! Disney has a positive Jensens alpha of 0.60% a year between 1999 and 2003.
This can be viewed as a sign that management in the rm did a good job,
managing the rm during the period.
a) True
b) False
This is not necessarily true. In fact, the average Jensens alpha across
entertainment companies during this period was 1.33% (annualized). This
would suggest that Disney underperformed the sector by 0.70%. In fact, a
companys positive Jensens alpha can be entirely attributable to sector
performance. Conversely, a company can have a negative Jensens alpha and
impeccable management at the same time.
Aswath Damodaran 113
Estimating Disneys Beta
! Slope of the Regression of 1.01 is the beta
! Regression parameters are always estimated with error. The error is captured
in the standard error of the beta estimate, which in the case of Disney is 0.20.
! Assume that I asked you what Disneys true beta is, after this regression.
What is your best point estimate?
What range would you give me, with 67% condence?
What range would you give me, with 95% condence?
Best point estimate: 1.01
Range with 67% condence: 0.81-1.21
Range with 95% condence: 0.61 - 1.41
Aswath Damodaran 114
The Dirty Secret of Standard Error
Di str i buti on of Standar d Er r or s: Beta Esti mates for U.S. stocks
0
200
400
600
800
1000
1200
1400
1600
<.10 .10 - .20 .20 - .30 .30 - .40 .40 - .50 .50 - .75 >.75
Standar d Er r or i n Beta Esti mate
N
u
m
b
e
r
o
f
F
i
r
m
s
The standard errors of betas estimated in the US tend to be fairly high, with
many beta estimates having standard errors of 0.40 or greater. These betas
should come with warnings.
Aswath Damodaran 115
Breaking down Disneys Risk
! R Squared = 29%
! This implies that
29% of the risk at Disney comes from market sources
71%, therefore, comes from rm-specic sources
! The rm-specic risk is diversiable and will not be rewarded
This again is well in line with typical rms in the US. The typical rm has an R
squared of between 20-25%. Hence, the allure of diversication.
Aswath Damodaran 116
The Relevance of R Squared
You are a diversied investor trying to decide whether you should invest in
Disney or Amgen. They both have betas of 1.01, but Disney has an R
Squared of 29% while Amgens R squared of only 14.5%. Which one would
you invest in?
a) Amgen, because it has the lower R squared
b) Disney, because it has the higher R squared
c) You would be indifferent
Would your answer be different if you were an undiversied investor?
If you were a diversied investor, you would not care, since you would diversify
away all of the undiversiable risk anyway. If you were undiversied, you
would prefer Disney, which has less rm-specic risk.
Aswath Damodaran 117
Beta Estimation: Using a Service (Bloomberg)
This is the page for Disneys beta, using the same period as the regression run
earlier, from Bloomberg.
Bloomberg, however, uses only price returns (it ignores dividends both in the
stock and the index). Hence the intercept is different.
The adjusted beta is just the regression beta moves towards one, reecting the
empirical realities that for most rms, betas tend to drift towards one as they get
larger and more diversied.
Aswath Damodaran 118
Estimating Expected Returns for Disney in September 2004
! Inputs to the expected return calculation
Disneys Beta = 1.01
Riskfree Rate = 4.00% (U.S. ten-year T.Bond rate)
Risk Premium = 4.82% (Approximate historical premium: 1928-2003)
! Expected Return = Riskfree Rate + Beta (Risk Premium)
= 4.00% + 1.01(4.82%) = 8.87%
Note that this expected return would have been different if we had decided to
use a different historical premium or the implied premium.
Aswath Damodaran 119
Use to a Potential Investor in Disney
As a potential investor in Disney, what does this expected return of 8.87% tell
you?
a) This is the return that I can expect to make in the long term on Disney, if the stock
is correctly priced and the CAPM is the right model for risk,
b) This is the return that I need to make on Disney in the long term to break even on
my investment in the stock
c) Both
Assume now that you are an active investor and that your research suggests that
an investment in Disney will yield 12.5% a year for the next 5 years. Based
upon the expected return of 8.87%, you would
a) Buy the stock
b) Sell the stock
Both. If the stock is correctly priced, the beta is correctly estimated and the
CAPM is the right model, this is what you would expect to make on Disney in
the long term. As an investor, this is what you would need to make to break even
on the investment.
Buy the stock, since you think you can make more than the hurdle rate.
Aswath Damodaran 120
How managers use this expected return
! Managers at Disney
need to make at least 8.87% as a return for their equity investors to break even.
this is the hurdle rate for projects, when the investment is analyzed from an equity
standpoint
! In other words, Disneys cost of equity is 8.87%.
! What is the cost of not delivering this cost of equity?
The cost of equity is what equity investors in your company view as their
required return.
The cost of not delivering this return is more unhappy stockholders, a lower
stock price, and if you are a manager, maybe your job.
Going back to the corporate governance section, if stockholders have little or no
control over managers, managers are less likely to view this as the cost of equity.
Aswath Damodaran 121
! Application Test: Analyzing the Risk Regression
! Using your Bloomberg risk and return print out, answer the following
questions:
How well or badly did your stock do, relative to the market, during the period of
the regression? (You can assume an annualized riskfree rate of 4.8% during the
regression period)
Intercept - (4.8%/n) (1- Beta) = Jensens Alpha
Where n is the number of return periods in a year (12 if monthly; 52 if monthly)
What proportion of the risk in your stock is attributable to the market? What
proportion is rm-specic?
What is the historical estimate of beta for your stock? What is the range on this
estimate with 67% probability? With 95% probability?
Based upon this beta, what is your estimate of the required return on this stock?
Riskless Rate + Beta * Risk Premium
Try this on your company.
Aswath Damodaran 122
A Quick Test
You are advising a very risky software rm on the right cost of equity to use in
project analysis. You estimate a beta of 3.0 for the rm and come up with a
cost of equity of 18.46%. The CFO of the rm is concerned about the high
cost of equity and wants to know whether there is anything he can do to
lower his beta.
How do you bring your beta down?
Should you focus your attention on bringing your beta down?
a) Yes
b) No
There are three ways to bring your beta down:
Pay off debt, if you have any
Move into safer businesses
Sell off assets, and keep cash on your balance sheet
No. What matters is the difference between what you make on your projects
(return on equity) and your cost of equity. If you lower your cost of equity, but
lower your return on equity even more, you are not serving your stockholders.
Aswath Damodaran 123
Disneys Beta Calculation: A look back at 1997-2002
Jensens alpha = -0.39% -
0.30 (1 - 0.94) = -0.41%
Annualized = (1-
.0041)^12-1 = -4.79%
If you go back 12 months, the conclusions on Disneys performance would
have been much more negative.
Jensens alpha = -0.39% - 0.30 (1 - 0.94) = -0.41% ! Monthly riskfree rate
during the period is 0.30%)
Annualized Jensens alpha = (1-.0041)^12-1 = -4.79%
Aswath Damodaran 124
Beta Estimation and Index Choice: Deutsche Bank
Note that Deutsche Bank is about 8% of the DAX.
Aswath Damodaran 125
A Few Questions
! The R squared for Deutsche Bank is very high (62%), at least relative to U.S.
rms. Why is that?
! The beta for Deutsche Bank is 1.04.
Is this an appropriate measure of risk?
If not, why not?
! If you were an investor in primarily U.S. stocks, would this be an appropriate
measure of risk?
The R-squared is high, because Deutsche Bank is such a large percentage of the
index.
This beta is a reasonable measure of risk only to those whose entire portfolio is
composed of large German companies.
If you were primarily a US investor, you would look at the risk that DBK would
add on to a US index.
Aswath Damodaran 126
Deutsche Bank: Alternate views of Risk
DAX FTSE Euro
300
MSCI
Intercept
1.24% 1.54% 1.37%
Beta 1.05 1.52 1.23
Std Error of
Beta
0.11 0.19 0.25
R Squared 62% 52% 30%
As the index used expands and becomes broader, the R-squared drops off and
the standard error increases. The least precise beta estimate (with the highest
standard error) may be the most meaningful.
Aswath Damodaran 127
Aracruzs Beta?
Aracruz ADR vs S&P 500
S&P
20 10 0 -10 -20
A
r
a
c
r
u
z
A
D
R
80
60
40
20
0
-20
-40
Aracruz vs Bovespa
BOVESPA
30 20 10 0 -10 -20 -30 -40 -50
A
r
a
c
r
u
z
140
120
100
80
60
40
20
0
-20
-40
A r a c r u z ADR = 2.80% + 1.00 S&P Ar acr uz = 2.62% + 0.22 Bovespa
Two very different views of Aracruzs risk. Which one is the right one?
The Bovespa is a narrow index and Aracruzs beta estimated against it may tell
us nothing about its risk.
The regression against the S&P 500 is more informative, but the standard error
is large
Aswath Damodaran 128
Beta: Exploring Fundamentals
Beta = 1
Beta > 1
Beta = 0
Beta < 1
Real Networks: 3.24
Qwest Communications: 2.60
General Electric: 1.10
Microsoft: 1..25
Philip Morris: 0.65
Exxon Mobil: 0.40
Harmony Gold Mining: - 0.10
Enron: 0.95
Aswath Damodaran 129
Determinant 1: Product Type
! Industry Effects: The beta value for a rm depends upon the sensitivity of
the demand for its products and services and of its costs to macroeconomic
factors that affect the overall market.
Cyclical companies have higher betas than non-cyclical rms
Firms which sell more discretionary products will have higher betas than rms that
sell less discretionary products
Betas measure risk relative to the market.
Firms which are cyclical or sell discretionary products tend to do much better
when the economy is doing well (and the market is doing well) and much worse
when the economy is doing badly than other rms in the market.
Aswath Damodaran 130
A Simple Test
Consider an investment in Tiffanys. What kind of beta do you think this
investment will have?
a) Much higher than one
b) Close to one
c) Much lower than one
Much Higher than one. Most of the products sold by Tiffanys are
discretionary.
Aswath Damodaran 131
Determinant 2: Operating Leverage Effects
! Operating leverage refers to the proportion of the total costs of the rm that
are xed.
! Other things remaining equal, higher operating leverage results in greater
earnings variability which in turn results in higher betas.
Firms with high xed costs tend to see much bigger swings in operating income
(and stock prices) for a given change in revenues than rms with more exible
cost structures.
Consider the case of the airline sector, which tends to have cost structures which
are almost entirely xed (plane lease expenses, fuel costs )
Aswath Damodaran 132
Measures of Operating Leverage
Fixed Costs Measure = Fixed Costs / Variable Costs
! This measures the relationship between xed and variable costs. The higher
the proportion, the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues
! This measures how quickly the earnings before interest and taxes changes as
revenue changes. The higher this number, the greater the operating leverage.
The direct measures of xed costs and variable costs are difcult to obtain.
Hence we use the second.
Aswath Damodaran 133
Disneys Operating Leverage: 1987- 2003
Year Net Sales % Change
in Sales
EBIT % Change
in EBIT
1987 2877 756
1988 3438 19.50% 848 12.17%
1989 4594 33.62% 1177 38.80%
1990 5844 27.21% 1368 16.23%
1991 6182 5.78% 1124 -17.84%
1992 7504 21.38% 1287 14.50%
1993 8529 13.66% 1560 21.21%
1994 10055 17.89% 1804 15.64%
1995 12112 20.46% 2262 25.39%
1996 18739 54.71% 3024 33.69%
1997 22473 19.93% 3945 30.46%
1998 22976 2.24% 3843 -2.59%
1999 23435 2.00% 3580 -6.84%
2000 25418 8.46% 2525 -29.47%
2001 25172 -0.97% 2832 12.16%
2002 25329 0.62% 2384 -15.82%
2003 27061 6.84% 2713 13.80%
1987-2003 15.83% 10.09%
1996-2003 11.73% 4.42%
This measures Disneys operating leverage historically. You need a number of
years of data before you can get reasonable estimates.
Aswath Damodaran 134
Reading Disneys Operating Leverage
! Operating Leverage = % Change in EBIT/ % Change in Sales
= 10.09% / 15.83% = 0.64
! This is lower than the operating leverage for other entertainment rms, which
we computed to be 1.12. This would suggest that Disney has lower xed costs
than its competitors.
! The acquisition of Capital Cities by Disney in 1996 may be skewing the
operating leverage. Looking at the changes since then:
Operating Leverage
1996-03
= 4.42%/11.73% = 0.38
Looks like Disneys operating leverage has decreased since 1996.
The operating leverage number makes sense only when compared to industry
averages or historical averages. It is the relative operating leverage that affects
betas.
Aswath Damodaran 135
A Test
Assume that you are comparing a European automobile manufacturing rm with
a U.S. automobile rm. European rms are generally much more constrained
in terms of laying off employees, if they get into nancial trouble. What
implications does this have for betas, if they are estimated relative to a
common index?
a) European rms will have much higher betas than U.S. rms
b) European rms will have similar betas to U.S. rms
c) European rms will have much lower betas than U.S. rms
European rms will have more xed costs, leading to higher betas. This might
put these rms at a competitive disadvantage relative to US rms.
Are there ways in which you can bring your operating leverage down as a rm?
Make more of your xed costs into variable costs (Build in escape
clauses into lease agreements, for instance). Negotiate exibility in wage
contracts or use part time employees to deal with surplus business.
Spin off assets that are capital intensive (Coca Cola spun off its bottlers
in the early 1980s)
Aswath Damodaran 136
Determinant 3: Financial Leverage
! As rms borrow, they create xed costs (interest payments) that make their
earnings to equity investors more volatile.
! This increased earnings volatility which increases the equity beta
Same rationale as operating leverage.
Aswath Damodaran 137
Equity Betas and Leverage
! The beta of equity alone can be written as a function of the unlevered beta and
the debt-equity ratio
"
L
= "
u
(1+ ((1-t)D/E))
where
"
L
= Levered or Equity Beta
"
u
= Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
This is based upon two assumptions
Debt bears no market risk (which is consistent with studies that have
found that default risk is non-systematic)
Debt creates a tax benet
Assets Liabilities
Assets A ("
u
) Debt D ("
D
=0)
Tax Benets tD ("
D
=0) Equity E ("
L
)
Betas are weighted averages,
#
u
(E + D - tD)/(D+E) = "
L
(E/(D+E))
Solve for "
L
,
"
L
= #
u
(E + D - tD)/E= #
u
(1 + (1-t)D/E)
If debt has a beta ("
D
)
#
u
(E + D - tD)/(D+E) + "
D
tD/(D+E) = "
L
(E/(D+E)) + "
D
D/(D+E)
"
L
= #
u
(1 + (1-t)D/E) - "
D
(1-t) [D/(D+E)]
Aswath Damodaran 138
Effects of leverage on betas: Disney
! The regression beta for Disney is 1.01. This beta is a levered beta (because it
is based on stock prices, which reect leverage) and the leverage implicit in
the beta estimate is the average market debt equity ratio during the period of
the regression (1999 to 2003)
! The average debt equity ratio during this period was 27.5%.
! The unlevered beta for Disney can then be estimated (using a marginal tax
rate of 37.3%)
= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
= 1.01 / (1 + (1 - 0.373)) (0.275) = 0.8615
Note that betas reect the average leverage over the period and not the current
leverage of the rms. Firms whose leverage has changed over the period will
have regression betas that are different from their true betas.
Aswath Damodaran 139
Disney : Beta and Leverage
Debt to Capital Debt/Equity Ratio Beta Effect of Leverage
0.00% 0.00% 0.86 0.00
10.00% 11.11% 0.92 0.06
20.00% 25.00% 1.00 0.14
30.00% 42.86% 1.09 0.23
40.00% 66.67% 1.22 0.36
50.00% 100.00% 1.40 0.54
60.00% 150.00% 1.67 0.81
70.00% 233.33% 2.12 1.26
80.00% 400.00% 3.02 2.16
90.00% 900.00% 5.72 4.86
Since equity investors bear all of the non-diversiable risk, the beta of Disneys
equity will increase as the leverage increases.
Aswath Damodaran 140
Betas are weighted Averages
! The beta of a portfolio is always the market-value weighted average of the
betas of the individual investments in that portfolio.
! Thus,
the beta of a mutual fund is the weighted average of the betas of the stocks and
other investment in that portfolio
the beta of a rm after a merger is the market-value weighted average of the betas
of the companies involved in the merger.
Betas are always weighted averages - where the weights are based upon market
value. This is because betas measure risk relative to a market index.
Aswath Damodaran 141
The Disney/Cap Cities Merger: Pre-Merger
Disney:
! Beta = 1.15
! Debt = $ 3,186 million Equity = $ 31,100 million Firm = $34,286
! D/E = 0.10
ABC:
! Beta = 0.95
! Debt = $ 615 million Equity = $ 18,500 million Firm= $ 19,115
! D/E = 0.03
These are the betas of the rms at the time of Disneys acquisition. The tax rate
used for both betas is 36%.
Aswath Damodaran 142
Disney Cap Cities Beta Estimation: Step 1
! Calculate the unlevered betas for both rms
Disneys unlevered beta = 1.15/(1+0.64*0.10) = 1.08
Cap Cities unlevered beta = 0.95/(1+0.64*0.03) = 0.93
! Calculate the unlevered beta for the combined rm
Unlevered Beta for combined rm
= 1.08 (34286/53401) + 0.93 (19115/53401)
= 1.026
[Remember to calculate the weights using the rm values of the two rms]
The unlevered beta of the combined rm will always be the weighted average of
the two rms unlevered betas. The rm values (rather than the equity values) are
used for the weights because we are looking at the unlevered betas of the rms .
Aswath Damodaran 143
Disney Cap Cities Beta Estimation: Step 2
! If Disney had used all equity to buy Cap Cities
Debt = $ 615 + $ 3,186 = $ 3,801 million
Equity = $ 18,500 + $ 31,100 = $ 49,600
D/E Ratio = 3,801/49600 = 7.66%
New Beta = 1.026 (1 + 0.64 (.0766)) = 1.08
! Since Disney borrowed $ 10 billion to buy Cap Cities/ABC
Debt = $ 615 + $ 3,186 + $ 10,000 = $ 13,801 million
Equity = $ 39,600
D/E Ratio = 13,801/39600 = 34.82%
New Beta = 1.026 (1 + 0.64 (.3482)) = 1.25
This reects the effects of the nancing of the acquisition. In the second
scenario, note that $ 10 billion of the $ 18.5 billion is borrowed. The remaining
$ 8.5 billion has to come from new equity issues.
Exercise: What would Disneys beta be if it had borrowed the entire $ 18.5
billion?
Debt = $ 615 + $ 3,186 + $ 18,500 = $ 22,301 million
Equity = $ 31,100 million
D/E Ratio = 71.70%
New Beta = 1.026 ( 1 + 0.64 (.717)) = 1.50
Aswath Damodaran 144
Firm Betas versus divisional Betas
! Firm Betas as weighted averages: The beta of a rm is the weighted average
of the betas of its individual projects.
! At a broader level of aggregation, the beta of a rm is the weighted average of
the betas of its individual division.
The same principle applies to a rm. To the degree that the rm is in multiple
businesses, its beta reects all of these businesses.
Aswath Damodaran 145
Bottom-up versus Top-down Beta
! The top-down beta for a rm comes from a regression
! The bottom up beta can be estimated by doing the following:
Find out the businesses that a rm operates in
Find the unlevered betas of other rms in these businesses
Take a weighted (by sales or operating income) average of these unlevered betas
Lever up using the rms debt/equity ratio
! The bottom up beta will give you a better estimate of the true beta when
the standard error of the beta from the regression is high (and) the beta for a rm is
very different from the average for the business
the rm has reorganized or restructured itself substantially during the period of the
regression
when a rm is not traded
Bottom-up betas build up to the beta from the fundamentals, rather than trusting
the regression.
The standard error of an average beta for a sector, is smaller by a factor of ! n,
where n is the number of rms in the sector. Thus, if there are 25 rms in a
sector, the standard error of the average is 1/5 the average standard error.
Aswath Damodaran 146
Disneys business breakdown
Business
Comparable
fi rms
Number
of firms
Average
levered
bet a
Median
D/ E
Unlevered
bet a
Cash/Firm
Val ue
Unlevered
beta
corrected
for cash
Media
Networks
Radia and TV
broadcasting
companies 2 4 1. 22 20.45% 1.0768 0. 75% 1.0850
Parks and
Resorts
Theme park &
Entertainment
fi rms 9 1. 58 120.76 % 0.8853 2. 77% 0.9105
Studio
Entertainment
Movie
companies 1 1 1. 16 27.96% 0.9824 14.08% 1.1435
Consumer
Products
Toy and
apparel
retailers;
Entertainment
software 7 7 1. 06 9. 18% 0.9981 12.08% 1.1353
Diosney has other businesses (like cruise lines) which are not broken out
separately because they are too small There is also a trade off to breaking
businesses down too much into subsectors, since it becomes more difcult
to nd comparable rms.
Estimating details:
1. Comparable rms: get 75% or more of their revenues from the stated
business
2. Average levered beta: Simple average of two-year weekly return betas for
comparable rms.
3. Cash / Firm value: Cash holdings as a percent of rm value at comparable
rms
4. Unlevered beta corrected for cash: Unlevered beta/ (1 - Cash/ Firm Value).
We are assuming that cash has a beta of zero.
Aswath Damodaran 147
Disneys bottom up beta
Business
Revenues
in 2002 EV/Sales
Estimated
Value
Firm
Value
Proportion
Unlevered
beta
Media
Networks $10,941 3.41 $37,278.62 49.25% 1.0850
Parks and
Resorts $6,412 2.37 $15,208.37 20.09% 0.9105
Studio
Entertainment $7,364 2.63 $19,390.14 25.62% 1.1435
Consumer
Products $2,344 1.63 $3,814.38 5.04% 1.1353
Disney $27,061 $75,691.51 100.00% 1.0674
EV/Sales = (Market Value of Equity + Market value of debt - Cash)/Sales. The
number reported here is the average across the comparable rms.
Aswath Damodaran 148
Disneys Cost of Equity
Business Unlevered Beta
D/E
Ratio
Levered
Beta
Cost of
Equity
Media Networks 1.0850 26.62% 1.2661 10.10%
Parks and
Resorts 0.9105 26.62% 1.0625 9.12%
Studio
Entertainment 1.1435 26.62% 1.3344 10.43%
Consumer
Products 1.1353 26.62% 1.3248 10.39%
Disney 1.0674 26.62% 1.2456 10.00%
We are using Disneys debt to equity ratio as the debt to equity ratio for each of
its divisions since the divisision dont carry their own debt. Optimally, you
would like to break the debt down by division, estimate a value of equity for
each division and come up with a debt to equity ratio for each division.
Aswath Damodaran 149
Discussion Issue
! If you were the chief nancial ofcer of Disney, what cost of equity would
you use in capital budgeting in the different divisions?
a) The cost of equity for Disney as a company
b) The cost of equity for each of Disneys divisions?
The cost of equity for each division should be used. Otherwise, the riskier
divisions will over invest and the safest divisions will under invest.
Over time, the rm will become a riskier rm. Think of Bankers Trust from
1980, when it was a commercial bank, to 1992, when it had become primarily an
investment bank.
Aswath Damodaran 150
Estimating Aracruzs Bottom Up Beta
Comparables No Avg " D/E "
Unlev
Cash/Val "
Correct
Emerging Markets 111 0.6895 38.33% 0.5469 6.58% 0.5855
US 34 0.7927 83.57% 0.5137 2.09% 0.5246
Global 288 0.6333 38.88% 0.5024 6.54% 0.5375
! Aracruz has a cash balance which was 7.07% of the market value :
Unlevered Beta for Aracruz = (0.9293) (0.585) + (0.0707) (0) = 0.5440
! Using Aracruzs gross D/E ratio of 44.59% & a tax rate of 34%:
Levered Beta for Aracruz = 0.5440 (1+ (1-.34) (.4459)) = 0.7040
! The levered beta for just the paper business can also be computed:
Levered Beta for paper business = 0.585 (1+ (1-.34) (.4459))) = 0.7576
The tax rates used were 32% for emerging market companies, 35% for U.S.
companies and 33% for Global companies, based upon averaging the marginal
tax rates in each group.
This is a solution to the problems associated with estimating betas for emerging
markets. Use bottom-up betas and lever up.
Note that
Firms which carry disproportionate amounts of cash (greater than is
typical for the sector) should have lower betas.
If they hold marketable securities (or stocks) the beta of these securities
can be used in computing the weighted average.
Aswath Damodaran 151
Aracruz: Cost of Equity Calculation
! We will use a risk premium of 12.49% in computing the cost of equity,
composed of the U.S. historical risk premium (4.82% from 28-03) and the
Brazil country risk premium of 7.67% (estimated earlier in the package)
! U.S. $ Cost of Equity
Cost of Equity = 10-yr T.Bond rate + Beta * Risk Premium
= 4% + 0.7040 (12.49%) = 12.79%
! Real Cost of Equity
Cost of Equity = 10-yr Ination-indexed T.Bond rate + Beta * Risk Premium
= 2% + 0.7040 (12.49%) = 10.79%
! Nominal BR Cost of Equity
Cost of Equity =
= 1.1279 (1.08/1.02) -1 = .1943 or 19.43%
!
(1+$ Cost of Equity)
(1+ Inflation Rate
Brazil
)
(1+ Inflation Rate
US
)
"1
The cost of equity can be stated in different currencies. When computing the
nominal BR cost of equity, we scale up the risk premium to reect the fact the
the ination rates (and risk free rates in BR) are much higher.
Aswath Damodaran 152
Estimating Bottom-up Beta: Deutsche Bank
! Deutsche Bank is in two different segments of business - commercial banking
and investment banking.
To estimate its commercial banking beta, we will use the average beta of
commercial banks in Germany.
To estimate the investment banking beta, we will use the average bet of investment
banks in the U.S and U.K.
! To estimate the cost of equity in Euros, we will use the German 10-year bond
rate of 4.05% as the riskfree rate and the US historical risk premium (4.82%)
as our proxy for a mature market premium.
Business Beta Cost of Equity Weights
Commercial Banking 0.7345 7.59% 69.03%
Investment Banking 1.5167 11.36% 30.97%
Deutsche Bank 8.76%
Same process for Deutsche Bank. The only difference is that leverage is ignored
because it is a nancial service rm. It is implicitly assumed that banks tend to
have similar leverage.
We use the German 10-year bond rate, not because Deutsche is a German
company, but because the German 10-year Euro bond had the lowest interest
rate of all European 10-year bonds (and thus most likely to be default free).
Aswath Damodaran 153
Estimating Betas for Non-Traded Assets
! The conventional approaches of estimating betas from regressions do not
work for assets that are not traded.
! There are two ways in which betas can be estimated for non-traded assets
using comparable rms
using accounting earnings
Private rms are not traded. There are no historical price records to compute
betas from.
Aswath Damodaran 154
Using comparable rms to estimate beta for Bookscape
Assume that you are trying to estimate the beta for a independent bookstore in
New York City.
Firm Beta Debt Equity Cash
Books-A-Million 0.532 $45 $45 $5
Borders Group 0.844 $182 $1,430 $269
Barnes & Noble 0.885 $300 $1,606 $268
Courier Corp 0.815 $1 $285 $6
Info Holdings 0.883 $2 $371 $54
John Wiley &Son 0.636 $235 $1,662 $33
Scholastic Corp 0.744 $549 $1,063 $11
Sector 0.7627 $1,314 $6,462 $645
Unlevered Beta = 0.7627/(1+(1-.35)(1314/6462)) = 0.6737
Corrected for Cash = 0.6737 / (1 645/(1314+6462)) = 0.7346
This is the bottom-up beta for a private book store. The beta can be estimated
assuming that the business has the same or different leverage as comparable
rms. (All you have for private rms is book value debt and equity)
Aswath Damodaran 155
Estimating Bookscape Levered Beta and Cost of Equity
! Since the debt/equity ratios used are market debt equity ratios, and the only
debt equity ratio we can compute for Bookscape is a book value debt equity
ratio, we have assumed that Bookscape is close to the industry average debt
to equity ratio of 20.33%.
! Using a marginal tax rate of 40% (based upon personal income tax rates) for
Bookscape, we get a levered beta of 0.82.
Levered beta for Bookscape = 0.7346 (1 +(1-.40) (.2033)) = 0.82
! Using a riskfree rate of 4% (US treasury bond rate) and a historical risk
premium of 4.82%:
Cost of Equity = 4% + 0.82 (4.82%) = 7.95%
Aswath Damodaran 156
Using Accounting Earnings to Estimate Beta
Year S&P 500 Bookscape Year S&P 500 Bookscape
1980 3.01% 3.55% 1991 -12.08% -32.00%
1981 1.31% 4.05% 1992 -5.12% 55.00%
1982 -8.95% -14.33% 1993 9.37% 31.00%
1983 -3.84% 47.55% 1994 36.45% 21.06%
1984 26.69% 65.00% 1995 30.70% 11.55%
1985 -6.91% 5.05% 1996 1.20% 19.88%
1986 -7.93% 8.50% 1997 10.57% 16.55%
1987 11.10% 37.00% 1998 -3.35% 7.10%
1988 42.02% 45.17% 1999 18.13% 14.40%
1989 5.52% 3.50% 2000 15.13% 10.50%
1990 -9.58% -10.50% 2001 -14.94% -8.15%
2002 6.81% 4.05%
Accounting betas are computed by regressing accounting earnings changes
against changes in earnings at the S&P 500.
Aswath Damodaran 157
The Accounting Beta for Bookscape
! Regressing the changes in prots at Bookscape against changes in prots for
the S&P 500 yields the following:
Bookscape Earnings Change Change = 0.1003 + 0.7329 (S & P 500 Earnings Change)
Based upon this regression, the beta for Bookscapes equity is 0.73.
! Using operating earnings for both the rm and the S&P 500 should yield the
equivalent of an unlevered beta.
The biggest problems with accounting betas are:
Earnings tend to be smoothed out
You will not have very many observations in your regression
Aswath Damodaran 158
Is Beta an Adequate Measure of Risk for a Private Firm?
! The owners of most private rms are not diversied. Beta measures the risk
added on to a diversied portfolio. Therefore, using beta to arrive at a cost of
equity for a private rm will
a) Under estimate the cost of equity for the private rm
b) Over estimate the cost of equity for the private rm
c) Could under or over estimate the cost of equity for the private rm
Using beta (that looks at only market risk) will tend to under estimate the cost of
equity since private owners feel exposed to all risk.
Aswath Damodaran 159
Total Risk versus Market Risk
! Adjust the beta to reect total risk rather than market risk. This adjustment is
a relatively simple one, since the R squared of the regression measures the
proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
! In the Bookscape example, where the market beta is 0.82 and the average R-
squared of the comparable publicly traded rms is 16%,
Total Cost of Equity = 4% + 2.06 (4.82%) = 13.93%
!
Market Beta
R squared
=
0.82
.16
= 2.06
This assumes that
The owner of the private business has all of his or her wealth invested in
the business
The reality is that most individuals will fall somewhere between the two
extremes.
If you were a private business looking at potential acquirers - one is a publicly
traded rm and the other is an individual . Which one is likely to pay the higher
price and why?
If both acquirers have the same cash ow expectations, the publicly
traded rm will win out (Blockbuster Video, Browning-Ferris are good
examples of publicly traded rms which bought small private businesses
to grow to their current stature.)
Aswath Damodaran 160
! Application Test: Estimating a Bottom-up Beta
! Based upon the business or businesses that your rm is in right now, and its
current nancial leverage, estimate the bottom-up unlevered beta for your
rm.
! Data Source: You can get a listing of unlevered betas by industry on my web
site by going to updated data.
The breakdown of a rm into businesses is available in the 10-K. The unlevered
betas are available on my web site.
Aswath Damodaran 161
From Cost of Equity to Cost of Capital
! The cost of capital is a composite cost to the rm of raising nancing to fund
its projects.
! In addition to equity, rms can raise capital from debt
Capital is more than just equity. It also includes other nancing sources,
including debt.
Aswath Damodaran 162
What is debt?
! General Rule: Debt generally has the following characteristics:
Commitment to make xed payments in the future
The xed payments are tax deductible
Failure to make the payments can lead to either default or loss of control of the
rm to the party to whom payments are due.
! As a consequence, debt should include
Any interest-bearing liability, whether short term or long term.
Any lease obligation, whether operating or capital.
Debt is not restricted to what gets called debt in the balance sheet. It includes
any nancing with these characteristics.
Aswath Damodaran 163
Estimating the Cost of Debt
! If the rm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used as the
interest rate.
! If the rm is rated, use the rating and a typical default spread on bonds with
that rating to estimate the cost of debt.
! If the rm is not rated,
and it has recently borrowed long term from a bank, use the interest rate on the
borrowing or
estimate a synthetic rating for the company, and use the synthetic rating to arrive at
a default spread and a cost of debt
! The cost of debt has to be estimated in the same currency as the cost of equity
and the cash ows in the valuation.
While the cost of debt can be estimated easily for some rms, by looking up
traded bonds, it can be more difcult for non-rated rms. The default spreads
can be obtained from
http://www.bondsonline.com
Aswath Damodaran 164
Estimating Synthetic Ratings
! The rating for a rm can be estimated using the nancial characteristics of the
rm. In its simplest form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
! For a rm, which has earnings before interest and taxes of $ 3,500 million and
interest expenses of $ 700 million
Interest Coverage Ratio = 3,500/700= 5.00
! In 2003, Bookscape had operating income of $ 2 million after interest
expenses of 5000,000. The resulting interest coverage ratio is 4.00.
Interest coverage ratio = 2,000,000/500,000 = 4.00
This is simplistic. A more realistic approach would use more than the interest
coverage ratio. In fact, we could construct a score based upon multiple ratios
(such as a Z-score) and use that score to estimate ratings.
Aswath Damodaran 165
Interest Coverage Ratios, Ratings and Default Spreads:
Small Companies
Interest Coverage Ratio Rating Typical default spread
> 12.5 AAA 0.35%
9.50 - 12.50 AA 0.50%
7.50 9.50 A+ 0.70%
6.00 7.50 A 0.85%
4.50 6.00 A- 1.00%
4.00 4.50 BBB 1.50%
3.50 - 4.00 BB+ 2.00%
3.00 3.50 BB 2.50%
2.50 3.00 B+ 3.25%
2.00 - 2.50 B 4.00%
1.50 2.00 B- 6.00%
1.25 1.50 CCC 8.00%
0.80 1.25 CC 10.00%
0.50 0.80 C 12.00%
< 0.65 D 20.00%
This table is constructed, using smaller non-nancial service companies (<$5
billion market cap) that are rated, and their interest coverage ratios. The rms
were sorted based upon their ratings, and the interest coverage range was
estimated.
These ranges will change over time, especially as the economy strengthens or
weakens. You can get the updated ranges on my web site.
Aswath Damodaran 166
Synthetic Rating and Cost of Debt for Bookscape
! Rating based on interest coverage ratio = BBB
! Default Spread based upon rating = 1.50%
! Pre-tax cost of debt = Riskfree Rate + Default Spread = 4% + 1.50% = 5.50%
! After-tax cost of debt = Pre-tax cost of debt (1- tax rate) = 5.50% (1-.40) =
3.30%
The tax rate used is the marginal tax rate. Interest savings you taxes on your
marginal income, not rst or average dollar of income.
Aswath Damodaran 167
Estimating Cost of Debt with rated companies
! For the three publicly traded rms in our sample, we will use the actual bond
ratings to estimate the costs of debt:
S&P Rating Riskfree Rate Default Cost of Tax After-tax
Spread Debt Rate Cost of Debt
Disney BBB+ 4% ($) 1.25% 5.25% 37.3% 3.29%
Deutsche Bank AA- 4.05% (Eu) 1.00% 5.05% 38% 3.13%
Aracruz B+ 4% ($) 3.25% 7.25% 34% 4.79%
! We computed the synthetic ratings for Disney and Aracruz using the interest
coverage ratios:
Disney: Coverage ratio = 2,805/758 =3.70 Synthetic rating = A-
Aracruz: Coverage ratio = 888/339= 2.62 Synthetic rating = BBB
Disneys synthetic rating is close to its actual rating. Aracruz has two ratings one
for its local currency borrowings of BBB- and one for its dollar borrowings of B+.
Can we trust rating agencies? In general, ratings agencies do a reasonable job of
assessing default risk and offer us these measures for free (at least to investors).
They have two faults: (1) They adjust for changes in default risk too slowly. All
too often ratings downgrades follow bond price declines and not the other way
around (2) They sometimes get caught up in the mood of the moment and either
overestimate default risk or underestimate default risk for an entire sector.
It is a good idea to estimate synthetic ratings even for rms that have actual
ratings. If there is disagreement between ratings agencies or a rm has multiple
bond ratings, the synthetic rating can operate as a tie-breaker. If there is a
signicant difference between actual and synthetic ratings and there is no
fundamental reason that can be pinpointed for the difference, the synthetic rating
may be providing an early signal of a ratings agency mistake.
Aswath Damodaran 168
! Application Test: Estimating a Cost of Debt
! Based upon your rms current earnings before interest and taxes, its interest
expenses, estimate
An interest coverage ratio for your rm
A synthetic rating for your rm (use the table from previous page)
A pre-tax cost of debt for your rm
An after-tax cost of debt for your rm
To estimate the after-tax cost of debt, you need a marginal tax rate. Since the
federal tax rate for corporations is 35%, I would expect the marginal tax rate to
be 35% of higher. Thus, even if the effective tax rate reported in the nancial
statements are lower, I would use at least 35%. If the effective tax rate is higher
than 35%, I would use the effective tax rate, with the assumption that it is
capturing other taxes that the rm has to pay.
Aswath Damodaran 169
Costs of Hybrids
! Preferred stock shares some of the characteristics of debt - the preferred
dividend is pre-specied at the time of the issue and is paid out before
common dividend -- and some of the characteristics of equity - the payments
of preferred dividend are not tax deductible. If preferred stock is viewed as
perpetual, the cost of preferred stock can be written as follows:
k
ps
= Preferred Dividend per share/ Market Price per preferred share
! Convertible debt is part debt (the bond part) and part equity (the conversion
option). It is best to break it up into its component parts and eliminate it from
the mix altogether.
The easiest way to break down a convertible bond is to value it as a straight
bond and to then assign the remaining market value to the conversion option. In
March 2004, Disney had convertible bonds outstanding with 19 years left to
maturity and a coupon rate of 2.125%, trading at $1,064 a bond. Holders of
this bond have the right to convert the bond into 33.9444 shares of stock
anytime over the bonds remaining life. To break the convertible bond into
straight bond and conversion option components, we will value the bond using
Disneys pre-tax cost of debt of 5.25%:
At this conversion ratio, the price that investors would be paying for
Disney shares would be $29.46, much higher than the stock price of
$20.46 prevailing at the time of the analysis.
This rate was based upon a 10-year treasury bond rate. If the 5-year
treasury bond rate had been substantially different, we would have
recomputed a pre-tax cost of debt by adding the default spread to the
5-year rate.
Straight Bond component
= Value of a 2.125% coupon bond due in 19 years with a market interest rate of
5.25%
= PV of $21.25 in coupons each year for 19 years + PV of $1000 at end of
year 19
The coupons are assumed to be annual. With semi-annual coupons,
you would divide the coupon by 2 and apply a semi-annual rate to
calculate the present value.
=
Conversion Option = Market value of convertible Value of straight
bond
= 1064 - $629.91 = $434.09
The straight bond component of $630 is treated as debt, while the conversion
option of $434 is treated as equity.
Aswath Damodaran 170
Weights for Cost of Capital Calculation
! The weights used in the cost of capital computation should be market values.
! There are three specious arguments used against market value
Book value is more reliable than market value because it is not as volatile: While
it is true that book value does not change as much as market value, this is more a
reection of weakness than strength
Using book value rather than market value is a more conservative approach to
estimating debt ratios: For most companies, using book values will yield a lower
cost of capital than using market value weights.
Since accounting returns are computed based upon book value, consistency
requires the use of book value in computing cost of capital: While it may seem
consistent to use book values for both accounting return and cost of capital
calculations, it does not make economic sense.
Assume that the market value debt ratio is 10%, while the book value debt
ratio is 30%, for a firm with a cost of equity of 15% and an after-tax cost of
debt of 5%. The cost of capital can be calculated as follows
With market value debt ratios: 15% (.9) + 5%
(.1) = 14%
With book value debt ratios: 15% (.7) + 5% (.3) = 12%
Which is the more conservative estimate?
Aswath Damodaran 171
Estimating Market Value Weights
! Market Value of Equity should include the following
Market Value of Shares outstanding
Market Value of Warrants outstanding
Market Value of Conversion Option in Convertible Bonds
! Market Value of Debt is more difcult to estimate because few rms have
only publicly traded debt. There are two solutions:
Assume book value of debt is equal to market value
Estimate the market value of debt from the book value
For Disney, with book value of 13,100 million, interest expenses of $666 million,
a current cost of borrowing of 5.25% and an weighted average maturity of 11.53
years.
Estimated MV of Disney Debt =
!
666
(1 "
1
(1.0525)
11.53
.0525
#
$
%
%
%
%
&
'
(
(
(
(
+
13,100
(1.0525)
11.53
= $12, 915 million
The market value of debt is estimated by considering all debt as if it were one
large coupon bond.
The average maturity of debt can be obtained from the 10-K. For Disney in
September 2004, the face-value weighted maturity in 2004 was 11.53 years
Aswath Damodaran 172
Converting Operating Leases to Debt
! The debt value of operating leases is the present value of the lease
payments, at a rate that reects their risk.
! In general, this rate will be close to or equal to the rate at which the company
can borrow.
This allows us to get a more realistic view of the leverage of rms that use
operating leases a lot. Examples would be the retailers like the Gap or Walmart.
Aswath Damodaran 173
Operating Leases at Disney
! The pre-tax cost of debt at Disney is 5.25%
Year Commitment Present Value
1 $ 271.00 $ 257.48
2 $ 242.00 $ 218.46
3 $ 221.00 $ 189.55
4 $ 208.00 $ 169.50
5 $ 275.00 $ 212.92
6 9 $ 258.25 $ 704.93
Debt Value of leases = $ 1,752.85
! Debt outstanding at Disney = $12,915 + $ 1,753= $14,668 million
The pre-tax cost of debt was based upon Disneys current rating.
Disney reports a lump sum of $ 1.033 billion as the amount due in year 6.
We break it up into four annual payments of $258.25 millijn a year based upon
the average lease payments over the rst 5 years
Aswath Damodaran 174
! Application Test: Estimating Market Value
! Estimate the
Market value of equity at your rm and Book Value of equity
Market value of debt and book value of debt (If you cannot nd the average
maturity of your debt, use 3 years): Remember to capitalize the value of operating
leases and add them on to both the book value and the market value of debt.
! Estimate the
Weights for equity and debt based upon market value
Weights for equity and debt based upon book value
Aswath Damodaran 175
Current Cost of Capital: Disney
! Equity
Cost of Equity = Riskfree rate + Beta * Risk Premium
= 4% + 1.25 (4.82%) = 10.00%
Market Value of Equity = $55.101 Billion
Equity/(Debt+Equity ) = 79%
! Debt
After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (4%+1.25%) (1-.373) = 3.29%
Market Value of Debt = $ 14.668 Billion
Debt/(Debt +Equity) = 21%
! Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59%
55.101(55.101+14.
668)
This reproduces the current cost of capital computation for Disney, using
market value weights for both debt and equity, the cost of equity (based upon
the bottom-up beta) and the cost of debt (based upon the bond rating)
The market value of debt is estimated by estimating the present value of total
interest payments and face value at the current cost of debt.
One way to frame the capital structure question: Is there a mix of debt and
equity at which Disneys cost of capital will be lower than 12.22%?
Aswath Damodaran 176
Disneys Divisional Costs of Capital
Business Cost of After-tax E/(D+E) D/(D+E) Cost of capital
Equity cost of debt
Media Networks 10.10% 3.29% 78.98% 21.02% 8.67%
Parks and Resorts 9.12% 3.29% 78.98% 21.02% 7.90%
Studio Entertainment 10.43% 3.29% 78.98% 21.02% 8.93%
Consumer Products 10.39% 3.29% 78.98% 21.02% 8.89%
Disney 10.00% 3.29% 78.98% 21.02% 8.59%
All of the divisions are assumed to share the same debt ratio and the cost of
debt. If they had borrowed on their own, we would have used division specic
debt ratios and costs of debt.
These would be the hurdle rates that we would use to analyze projects at each of
these divisions.
Aswath Damodaran 177
Aracruzs Cost of Capital
Levered Beta
Cost of
Equity
After-tax
Cost of Debt D/(D+E)
Cost of
Capital
In Real Terms
Paper &
Pulp 0.7576 11.46% 3.47% 30.82% 9.00%
Cash 0 2.00% 2.00%
Aracruz 0.7040 10.79% 3.47% 30.82% 8.53%
In US Dollar Terms
Paper &
Pulp 0.7576 13.46% 4.79% 30.82% 10.79%
Cash 0 4.00% 4.00%
Aracruz 0.7040 12.79% 4.79% 30.82% 10.33%
When computing cost of capital, we compute the cost both with cash as part of
the equation (in which case it is lower) and without cash.
Aswath Damodaran 178
Bookscape Cost of Capital
Beta Cost of After-tax D/(D+E) Cost of
Equity cost of debt Capital
Market Beta 0.82 7.97% 3.30% 16.90% 7.18%
Total Beta 2.06 13.93% 3.30% 16.90% 12.14%
If we assume that the owners of a private business are not diversied, we arrive
at much higher estimates of costs of equity and capital.
Aswath Damodaran 179
! Application Test: Estimating Cost of Capital
! Using the bottom-up unlevered beta that you computed for your rm, and the
values of debt and equity you have estimated for your rm, estimate a bottom-
up levered beta and cost of equity for your rm.
! Based upon the costs of equity and debt that you have estimated, and the
weights for each, estimate the cost of capital for your rm.
! How different would your cost of capital have been, if you used book value
weights?
Aswath Damodaran 180
Choosing a Hurdle Rate
! Either the cost of equity or the cost of capital can be used as a hurdle rate,
depending upon whether the returns measured are to equity investors or to all
claimholders on the rm (capital)
! If returns are measured to equity investors, the appropriate hurdle rate is the
cost of equity.
! If returns are measured to capital (or the rm), the appropriate hurdle rate is
the cost of capital.
While the cost of equity and capital can be very different numbers, they can both
be used as hurdle rates, as long as the returns and cash ows are dened
consistently.
Aswath Damodaran 181
Back to First Principles
! Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
The hurdle rate should be higher for riskier projects and reect the nancing
mix used - owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash ows generated and the
timing of these cash ows; they should also consider both positive and negative
side effects of these projects.
! Choose a nancing mix that minimizes the hurdle rate and matches the assets
being nanced.
! If there are not enough investments that earn the hurdle rate, return the cash to
stockholders.
The form of returns - dividends and stock buybacks - will depend upon the
stockholders characteristics.
Aswath Damodaran 182
Measuring Investment Returns
Show me the money
Jerry Maguire
Aswath Damodaran 183
First Principles
! Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
The hurdle rate should be higher for riskier projects and reect the nancing mix
used - owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash ows generated and
the timing of these cash ows; they should also consider both positive and
negative side effects of these projects.
! Choose a nancing mix that minimizes the hurdle rate and matches the assets
being nanced.
! If there are not enough investments that earn the hurdle rate, return the cash to
stockholders.
The form of returns - dividends and stock buybacks - will depend upon the
stockholders characteristics.
Aswath Damodaran 184
Measures of return: earnings versus cash ows
! Principles Governing Accounting Earnings Measurement
Accrual Accounting: Show revenues when products and services are sold or
provided, not when they are paid for. Show expenses associated with these
revenues rather than cash expenses.
Operating versus Capital Expenditures: Only expenses associated with creating
revenues in the current period should be treated as operating expenses. Expenses
that create benets over several periods are written off over multiple periods (as
depreciation or amortization)
! To get from accounting earnings to cash ows:
you have to add back non-cash expenses (like depreciation)
you have to subtract out cash outows which are not expensed (such as capital
expenditures)
you have to make accrual revenues and expenses into cash revenues and expenses
(by considering changes in working capital).
Accrual accounting income is designed to measure the income made by an
entity during a period, on sales made during the period. Thus, accrual
accounting draws lines between operating expenses (that create income in the
current period) and capital expenditures (which create income over multiple
periods).
It is not always consistent. R&D, for instance, is treated as an operating
expense.
Accrual accounting also tries to allocate the cost of materials to current period
revenues, leading to inventory, and give the company credit for sales made
during the period, even if cash has not been received, giving rise to accounts
receivable.
Aswath Damodaran 185
Measuring Returns Right: The Basic Principles
! Use cash ows rather than earnings. You cannot spend earnings.
! Use incremental cash ows relating to the investment decision, i.e.,
cashows that occur as a consequence of the decision, rather than total cash
ows.
! Use time weighted returns, i.e., value cash ows that occur earlier more
than cash ows that occur later.
The Return Mantra: Time-weighted, Incremental Cash Flow Return
These are the basic nancial principles underlying the measurement of
investment returns.
We focus on cash ows, because we cannot spend earnings.
We focus on incremental effects on the overall business, since we
care about the overall health and value of the business, not individual
projects.
We use time-weighted returns, since returns made earlier are worth more
than the same returns made later.
Aswath Damodaran 186
Earnings versus Cash Flows: A Disney Theme Park
! The theme parks to be built near Bangkok, modeled on Euro Disney in Paris,
will include a Magic Kingdom to be constructed, beginning immediately,
and becoming operational at the beginning of the second year, and a second
theme park modeled on Epcot Center at Orlando to be constructed in the
second and third year and becoming operational at the beginning of the fourth
year.
! The earnings and cash ows are estimated in nominal U.S. Dollars.
The earnings and cash ows will really be in Thai Baht. We will consider later
the effects of looking at all the cash ows in a different currency.
Note that this investment is not going to be fully operational until the fth year.
Aswath Damodaran 187
Key Assumptions on Start Up and Construction
! The cost of constructing Magic Kingdom will be $3 billion, with $ 2 billion to
be spent right now, and $1 Billion to be spent one year from now.
! Disney has already spent $0.5 Billion researching the proposal and getting the
necessary licenses for the park; none of this investment can be recovered if
the park is not built.
! The cost of constructing Epcot II will be $ 1.5 billion, with $ 1 billion to be
spent at the end of the second year and $0.5 billion at the end of the third year.
The emphasis in the rst item should be on already spent .
While we often classify all these investments as initial investments , they
occur over time.
Aswath Damodaran 188
Key Revenue Assumptions
Revenue estimates for the parks and resort properties (in millions)
Year Magic Kingdom Epcot II Resort Properties Total
1 $0 $0 $0 $0
2 $1,000 $0 $250 $1,250
3 $1,400 $0 $350 $3,000
4 $1,700 $300 $500 $4,250
5 $2,000 $500 $625 $5,625
6 $2,200 $550 $688 $6,563
7 $2,420 $605 $756 $7,219
8 $2,662 $666 $832 $7,941
9 $2,928 $732 $915 $8,735
10 $2,987 $747 $933 $9,242
Beyond Revenues grow 2% a year forever
These are assumptions. Most real investments involve uncertainty about the
future, but we have to make a judgment on what we expect to make. These
expectations may be based upon past experience or market testing.
Note that these are not conservative or low-ball estimates. Using lower numbers
than expected (because a project is risky or because you are risk-averse) can
lead to risk being double counted.
There is an alternative approach to capital budgeting where we can estimate what
are called certainty equivalent cash ows, but the discount rate in that case would
be the riskfree rate.
Finally, note that the project continues after year 10.
Aswath Damodaran 189
Key Expense Assumptions
! The operating expenses are assumed to be 60% of the revenues at the parks,
and 75% of revenues at the resort properties.
! Disney will also allocate corporate general and administrative costs to this
project, based upon revenues; the G&A allocation will be 15% of the
revenues each year. It is worth noting that a recent analysis of these expenses
found that only one-third of these expenses are variable (and a function of
total revenue) and that two-thirds are xed. After year 10, these expenses are
also assumed to grow at the ination rate of 2%.
Again, these numbers are easier to estimate in an investment like this one, where
Disney can look at similar investments that it has made in the past.
Most large rms have signicant expenses that cannot be traced to individual
projects. These expenses are sometimes lumped under General and
Administrative expenses (G&A) and get allocated to projects.
Aswath Damodaran 190
Depreciation and Capital Maintenance
Year Depreciation as % Capital Maintenance as %
of book value of Depreciation
1 0.00% 0.00%
2 12.70% 50.00%
3 11.21% 60.00%
4 9.77% 70.00%
5 8.29% 80.00%
6 8.31% 90.00%
7 8.34% 100.00%
8 8.38% 105.00%
9 8.42% 110.00%
10 8.42% 110.00%
!The capital maintenance expenditures are low in the early years, when the parks are still new but
increase as the parks age. After year 10, both depreciation and capital expenditures are assumed to grow
at the ination rate (2%).
This is accrual accounting at work. Some expenses such as regular maintenance
expenses will be treated as operating, but some expenses (such as replacing a
signicant portion of an existing ride) will be treated as capital expenditures.
The capital expenditures on this page are maintenance capital expenditures,
designed to keep the parks in operational condition, generating revenues in the
long term, and are on top of the initial capital expenditures.
The depreciation is the total depreciation on all cap ex. Note that capital
expenditures moves towards depreciation over time, reecting the fact that on an
innite-life project, depreciation is usually no longer a cash inow, since it has to
be reinvested back to sustain future growth.
Aswath Damodaran 191
Other Assumptions
! Disney will have to maintain non-cash working capital (primarily consisting
of inventory at the theme parks and the resort properties, netted against
accounts payable) of 5% of revenues, with the investments being made at the
end of each year.
! The income from the investment will be taxed at Disneys marginal tax rate of
37.3%
This will be a drain on the cash ows, since revenues are growing. This, in turn,
will create larger inventory and working capital needs each year, which will tie
up more cash in the project.
The tax rate used is the marginal tax rate (as opposed to the effective tax rate
reported in income statements and annual reports) because projects create
income at the margin and will be taxed at the margin.
Aswath Damodaran 192
Earnings on Project
Now (0) 1 2 3 4 5 6 7 8 9 10
Magic Kingdom $0 $1,000 $1,400 $1,700 $2,000 $2,200 $2,420 $2,662 $2,928 $2,987
Second Theme Park $0 $0 $0 $300 $500 $550 $605 $666 $732 $747
Resort & Properties $0 $250 $350 $500 $625 $688 $756 $832 $915 $933
Total Revenues $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,159 $4,575 $4,667
Magic Kingdom: Operating
Expenses $0 $600 $840 $1,020 $1,200 $1,320 $1,452 $1,597 $1,757 $1,792
Epcot II: Operating
Expenses $0 $0 $0 $180 $300 $330 $363 $399 $439 $448
Resort & Property:
Operating Expenses $0 $188 $263 $375 $469 $516 $567 $624 $686 $700
Depreciation & Amortization $0 $537 $508 $430 $359 $357 $358 $361 $366 $369
Allocated G&A Costs $0 $188 $263 $375 $469 $516 $567 $624 $686 $700
Operating Income $0 -$262 -$123 $120 $329 $399 $473 $554 $641 $657
Taxes $0 -$98 -$46 $45 $123 $149 $177 $206 $239 $245
Operating Income after
Taxes -$164 -$77 $75 $206 $250 $297 $347 $402 $412
This shows the accounting earnings calculations for the next 10 years. Note the
increasing after-tax operating income over time.
Aswath Damodaran 193
And the Accounting View of Return
Year
After-tax
Operating
Income
BV of
Capital:
Beginning
BV of
Capital:
Ending
Average BV
of Capital ROC
1 $0 $2,500 $3,500 $3,000 NA
2 -$165 $3,500 $4,294 $3,897 -4.22%
3 -$77 $4,294 $4,616 $4,455 -1.73%
4 $75 $4,616 $4,524 $4,570 1.65%
5 $206 $4,524 $4,484 $4,504 4.58%
6 $251 $4,484 $4,464 $4,474 5.60%
7 $297 $4,464 $4,481 $4,472 6.64%
8 $347 $4,481 $4,518 $4,499 7.72%
9 $402 $4,518 $4,575 $4,547 8.83%
10 $412 $4,575 $4,617 $4,596 8.97%
$175 $4,301 4.23%
This converts the accounting income into a percentage return (to enable us to do
the comparison to the hurdle rate, which is a percentage rate)
The average book value is computed each year using the beginning and ending
book values. The book values themselves are computed as follows:
Ending BV = Beginning BV - Depreciation + Capital Expenditures
Aswath Damodaran 194
Estimating a hurdle rate for the theme park
! We did estimate a cost of equity of 9.12% for the Disney theme park business
in the last chapter, using a bottom-up levered beta of 1.0625 for the business.
! This cost of equity may not adequately reect the additional risk associated
with the theme park being in an emerging market.
! To counter this risk, we compute the cost of equity for the theme park using a
risk premium that includes a country risk premium for Thailand:
The rating for Thailand is Baa1 and the default spread for the country bond is
1.50%. Multiplying this by the relative volatility of 2.2 of the equity market in
Thailand (strandard deviation of equity/standard devaiation of country bond) yields
a country risk premium of 3.3%.
Cost of Equity in US $= 4% + 1.0625 (4.82% + 3.30%) = 12.63%
Cost of Capital in US $ = 12.63% (.7898) + 3.29% (.2102) = 10.66%
Adds a risk premium to the cost of equity to reect the additional risk of
investing in an emerging market
Aswath Damodaran 195
Would lead us to conclude that...
! Do not invest in this park. The return on capital of 4.23% is lower than the
cost of capital for theme parks of 10.66%; This would suggest that the
project should not be taken.
! Given that we have computed the average over an arbitrary period of 10
years, while the theme park itself would have a life greater than 10 years,
would you feel comfortable with this conclusion?
a) Yes
b) No
I would not. I think the accounting return, which cuts of the analysis arbitrarily
after 10 years, understates the true return on projects like this one, which have
longer expected lives.
Aswath Damodaran 196
From Project to Firm Return on Capital: Disney in 2003
! Just as a comparison of project return on capital to the cost of capital yields a
measure of whether the project is acceptable, a comparison can be made at the
rm level, to judge whether the existing projects of the rm are adding or
destroying value.
! Disney, in 2003, had earnings before interest and taxes of $2,713 million, had
a book value of equity of $23,879 million and a book value of debt of 14,130
million. With a tax rate of 37.3%, we get
Return on Capital = 2713(1-.373)/ (23879+14130) = 4.48%
Cost of Capital for Disney= 8.59%
Excess Return = 4.49%-8.59% = -4.11%
! This can be converted into a dollar gure by multiplying by the capital
invested, in which case it is called economic value added
EVA = (..0448-.0859) (23879+14130) = -$1,562 million
A rm can be viewed as having a portfolio of existing projects. This approach
allows you to assess whether that portfolio is earning more than the hurdle rate,
but it is based upon the following assumptions:
Accounting earnings are a good measure of the earnings from current
projects (They might not be, if items like R&D, which are really
investments for the future, extraordinary prots or losses, or accounting
changes affect the reported income.)
The book value of capital is a good measure of what is invested in
current projects.
Aswath Damodaran 197
! Application Test: Assessing Investment Quality
! For the most recent period for which you have data, compute the after-tax
return on capital earned by your rm, where after-tax return on capital is
computed to be
After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of Equity)
previous year
! For the most recent period for which you have data, compute the return
spread earned by your rm:
Return Spread = After-tax ROC - Cost of Capital
! For the most recent period, compute the EVA earned by your rm
EVA = Return Spread * ((BV of debt + BV of Equity)
previous year
This measure of investment quality is only as good as the measures of operating
income and book value that go into it.
We use the book value of capital from the end of the previous year, because it is
more consistent with how we dene returns in nance. You could also do this on
the basis of the average operating income and capital.
Aswath Damodaran 198
The cash ow view of this project..